What Is a Deferred Tax Asset?
Items on a company's balance sheet that may be used to reduce taxable income in the future are called deferred tax assets. The situation can happen when a business overpaid taxes or paid taxes in advance on its balance sheet. These taxes are eventually returned to the business in the form of tax relief. Therefore, overpayment is considered an asset to the company. A deferred tax asset is the opposite of a deferred tax liability, which can increase the amount of income tax owed by a company.
- A deferred tax asset is an item on the balance sheet that results from overpayment or advance payment of taxes.
- It is the opposite of a deferred tax liability, which represents income taxes owed.
- A deferred tax asset can arise when there are differences in tax rules and accounting rules or when there is a carryover of tax losses.
- Beginning in 2018, most companies can carry over a deferred tax asset indefinitely.
Deferred Tax Asset
Understanding Deferred Tax Assets
Deferred tax assets are often created due to taxes paid or carried forward but not yet recognized on 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.
How Deferred Tax Assets Arise
The simplest 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 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 when 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% 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.
Important Considerations for Deferred Tax Assets
There are some key characteristics of deferred tax assets to consider. First, starting in the 2018 tax year, they can be carried forward indefinitely for most companies, but are no longer able to be carried back.
The second thing to consider is how tax rates affect the value of deferred tax assets. If the tax rate goes up, it works in 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.
Frequently Asked Questions
How do deferred tax assets arise?
A deferred tax asset is the result of a prepayment or overpayment of taxes that will be refunded or provide a benefit at some future point. Overpayments may arise due to changes in tax code or law that benefit the taxpayer.
Do deferred tax assets carry forward?
Yes. Beginning in 2018 taxpayers can carry deferred tax assets forward indefinitely.
How does a deferred tax asset differ from a deferred tax liability?
A deferred tax liability, instead of providing some value or benefit to the company or individual, instead represents a future tax obligation or payment due. For instance, retirement savers with 401(k) plans make contributions using pre-tax income. When money is eventually withdrawn from the account, income tax must be paid on those contributions. That eventual tax obligation is a deferred tax liability.