What Is a Deferred Tax Asset?

A deferred tax asset is an asset on a company's balance sheet that may be used to reduce its taxable income. It can refer to a situation where a business has overpaid taxes or taxes paid in advance on its balance sheet. These taxes are eventually returned to the business in the form of tax relief, and the over-payment is, therefore, an asset for the company.

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Deferred Tax Asset

Breaking Down Deferred Tax Asset

Deferred tax assets are often created due to taxes paid or carried forward but not yet recognized in the income statement. For example, deferred tax assets can be created due to the tax authorities recognizing revenue or expenses at different times than that of an accounting standard. This asset helps in reducing the company’s future tax liability. It is important to note that a deferred tax asset is recognized only when the difference between the loss-value or depreciation of the asset is expected to offset future profit.

A deferred tax asset can conceptually be compared to rent paid in advance or refundable insurance premiums; while the business no longer has cash on hand, it does have comparable value, and this must be reflected in its financial statements.

A deferred tax asset is the opposite of a deferred tax liability, which can increase the amount of income tax owed by a company. 

How Deferred Tax Assets Arise

The simplest example of a deferred tax asset is the carry-over of losses. If a business incurs a loss in a financial year, it usually is entitled to use that loss in order to lower its taxable income in the following years. In that sense, the loss is an asset.

Another scenario where deferred tax assets arise is where there is a difference between accounting rules and tax rules. For example, deferred taxes exist when expenses are recognized in the income statement before they are required to be recognized by the tax authorities or when revenue is subject to taxes before it is taxable in the income statement. Essentially, whenever the tax base or tax rules for assets and/or liabilities are different, there is an opportunity for the creation of a deferred tax asset.

Practical Example of Deferred Tax Asset Calculation

A computer manufacturing company estimates, based on previous experience, that the probability a computer may be sent back for warranty repairs in the next year is 2 percent out of the total production. If the company's total revenue in year one is $3,000 and the warranty expense in its books is $60 (2% x $3,000), then the company's taxable income is $2,940. However, most tax authorities do not allow companies to deduct expenses based on expected warranties, thus the company is required to pay taxes on the full $3,000.

If the tax rate for the company is 30 percent, the difference of $18 ($60 x 30%) between the taxes payable in the income statement and the actual taxes paid to the tax authorities is a deferred tax asset.

Important Considerations for Deferred Tax Assets

There are some key characteristics of deferred tax assets to consider. First, they come with an expiration date if they are not used up. Most of the time, they expire after 20 years. The second thing to consider is how tax rates affect the value of deferred tax assets. If the tax rate goes up, it works to the company’s favor because the assets’ values also go up, therefore providing a bigger cushion for a larger income. But if the tax rate drops, the tax asset value also declines. This means that the company may not be able to use the whole benefit before the expiration date.