What Is Deferred Tax Asset?
A deferred tax asset (DTA) represents a future tax saving that a company can realize. It arises in financial accounting when a company has overpaid its taxes or paid taxes in advance, or when it has deductible temporary differences or unused tax losses and credits that can be carried forward to offset future taxable income. Essentially, a deferred tax asset is a recognized asset on the balance sheet that reflects the expectation of lower future tax payments. This concept is central to financial accounting and taxation, specifically within the broader category of income tax accounting. A deferred tax asset often results from differences between how a company records revenues and expenses for financial reporting purposes ("book income") versus how it records them for tax purposes ("taxable income").
History and Origin
The concept of accounting for income taxes, including deferred tax assets, has evolved significantly through various accounting standards. In the United States, the primary guidance comes from the Financial Accounting Standards Board (FASB) Statement No. 109, "Accounting for Income Taxes" (SFAS 109), issued in February 1992. This standard superseded previous guidelines, most notably SFAS 96, and adopted an asset and liability approach, requiring the recognition of deferred tax assets and liabilities for the future tax consequences of events already recognized in financial statements or tax returns. SFAS 109 aimed to clarify the recognition methods for deferred tax assets and simplify the previously complex scheduling requirements. FASB Statement No. 109 was designed to make income tax accounting more understandable and decision-useful for financial statement users.8,7
Internationally, the International Accounting Standards Board (IASB) provides guidance through IAS 12, "Income Taxes." Adopted by the Board in April 2001, and originally issued by the International Accounting Standards Committee in October 1996, IAS 12 also employs a comprehensive balance sheet method, recognizing both current and future tax consequences. It dictates that deferred tax assets should be recognized when it is probable that future taxable profits will be available against which the deferred tax asset can be utilized.6,5
Key Takeaways
- A deferred tax asset arises when a company has paid more tax than is currently due or when future tax deductions are expected due to temporary differences between accounting and tax rules.
- Common sources of deferred tax assets include accrued expenses (like warranty provisions not yet tax-deductible), net operating losses carried forward, and certain tax credits.
- The realization of a deferred tax asset depends on a company generating sufficient future taxable income.
- A valuation allowance may be recorded against a deferred tax asset if it is more likely than not that some or all of the asset will not be realized.
- Deferred tax assets are reported on the balance sheet and represent a future economic benefit.
Formula and Calculation
A deferred tax asset arises from "deductible temporary differences" and "carryforwards." While there isn't a single universal formula for calculating the total deferred tax asset, the general principle for specific deductible temporary differences is:
[
\text{Deferred Tax Asset} = \text{Deductible Temporary Difference} \times \text{Enacted Future Tax Rate}
]
- Deductible Temporary Difference: This refers to the difference between the carrying amount (book value) and the tax base of an asset or liability that will result in future tax deductions. For example, if a company recognizes an expense in its income statement (reducing book income) but cannot deduct it for tax purposes until a later period, this creates a deductible temporary difference.
- Enacted Future Tax Rate: This is the corporate tax rate expected to be in effect when the temporary difference reverses or when the carryforward is utilized. Accounting standards require using currently enacted tax laws and rates, not anticipated future changes.
In addition to temporary differences, deferred tax assets can arise from unused net operating loss (NOL) carryforwards and unused tax credits. These amounts are also multiplied by the enacted tax rate to determine the deferred tax asset.
Interpreting the Deferred Tax Asset
Interpreting a deferred tax asset requires understanding its origin and the likelihood of its future realization. A significant deferred tax asset can indicate that a company has accumulated losses or has expensed items for financial reporting that are not yet deductible for tax purposes. While it represents a future tax benefit, its true value is contingent on the company generating sufficient taxable profits in subsequent periods.
Analysts often examine the components of a company's deferred tax asset, such as those arising from net operating losses or differences in depreciation methods. The presence and magnitude of a valuation allowance are critical for interpretation. If a large valuation allowance offsets a significant portion of the deferred tax asset, it signals that management believes it is unlikely the company will generate enough future taxable income to realize those tax benefits. This assessment of future profitability is a key judgment in bookkeeping.
Hypothetical Example
Consider "Tech Innovations Inc.," a growing software company. In its initial years, Tech Innovations incurs substantial research and development (R&D) expenses. For financial reporting, it expenses these R&D costs immediately, as per Generally Accepted Accounting Principles (GAAP). However, for tax purposes, some of these R&D costs might be capitalized and amortized over several years, or the company might accrue a significant warranty expense that is only deductible when paid.
Let's say in Year 1, Tech Innovations reports a pre-tax accounting profit of $1,000,000 but, due to these differences (e.g., $200,000 in R&D costs expensed for books but not for tax, and $50,000 in accrued warranty expense), its taxable income is $1,250,000. Assuming a corporate tax rate of 25%, the company pays $312,500 in current taxes ($1,250,000 * 0.25).
The deductible temporary difference is the sum of the R&D difference ($200,000) and the warranty difference ($50,000), totaling $250,000. This $250,000 represents expenses that will be tax-deductible in future periods.
Tech Innovations will record a deferred tax asset of $62,500 ($250,000 * 0.25) on its balance sheet. This deferred tax asset reflects the future tax savings the company expects to realize when these R&D costs become tax-deductible or the warranty liability is settled and paid in cash, reducing its future tax burden. This impacts the company's reported earnings per share.
Practical Applications
Deferred tax assets appear frequently in the financial statements of companies, stemming from various operational and accounting practices. One common application is in the treatment of net operating loss (NOL) carryforwards. When a company incurs a tax loss in a given year, tax regulations, such as those detailed in IRS Publication 536, often allow these losses to be carried forward to offset future taxable income.4 This creates a deferred tax asset, as the company anticipates reducing its future tax liability.
Another significant area is the difference in depreciation methods used for financial reporting versus tax purposes. Companies might use accelerated depreciation for tax purposes to reduce current taxable income, while using straight-line depreciation for financial reporting. This creates a temporary difference that can lead to a deferred tax asset if book depreciation is higher than tax depreciation in earlier years, or more commonly, a deferred tax liability if tax depreciation is higher. Similarly, certain accrued expenses, such as warranty provisions, employee benefits, or post-retirement obligations, are recognized in financial statements as expenses before they are actually paid and become tax-deductible. These timing differences lead to the recognition of a deferred tax asset. Understanding these applications is crucial for robust financial analysis.
Limitations and Criticisms
While deferred tax assets provide insight into a company's future tax benefits, they are subject to limitations and criticisms, primarily related to their realizability. The most significant limitation is that a deferred tax asset's value is contingent on the company generating sufficient future taxable income against which the asset can be offset. If a company consistently incurs losses or faces an uncertain future, the deferred tax asset may never be fully utilized.
This uncertainty often necessitates the establishment of a valuation allowance. A valuation allowance is a contra-asset account that reduces the net deferred tax asset to the amount that is "more likely than not" to be realized. The determination of whether a valuation allowance is needed, and its magnitude, involves significant managerial judgment and estimates regarding future profitability. This judgmental aspect can lead to concerns about the subjectivity of deferred tax asset reporting and its potential use in earnings management.3,2 Academic research has explored whether the existence and magnitude of valuation allowances are associated with indicators of future distress, suggesting they can be incrementally relevant to auditors' assessments of a company's likelihood of failure.1 Furthermore, changes in tax laws or rates can impact the value of a deferred tax asset, requiring adjustments that can introduce volatility into a company's reported earnings.
Deferred Tax Asset vs. Deferred Tax Liability
The concepts of deferred tax asset and deferred tax liability are two sides of the same coin in income tax accounting, both arising from temporary differences between the carrying amounts of assets and liabilities on a company's balance sheet and their respective tax bases.
A deferred tax asset signifies a future tax saving. It occurs when a company has paid more taxes than are currently owed, or when it has deductions or credits that can be used to reduce future tax payments. This typically happens when expenses are recognized sooner for financial reporting than for tax purposes (e.g., accrued warranty expenses) or when tax losses are carried forward. Essentially, the company has a prepaid tax benefit or a future tax deduction.
Conversely, a deferred tax liability represents a future tax payment obligation. It arises when a company has deferred paying taxes on income that has already been recognized for financial reporting, but not yet for tax purposes. This often occurs when income is recognized sooner for tax purposes than for financial reporting, or when accelerated depreciation is used for tax purposes, leading to lower taxable income in earlier periods but higher taxable income in later periods. In essence, the company owes taxes in the future on income that has already been booked.
Both are non-current items on the balance sheet, reflecting the long-term nature of these timing differences.
FAQs
What is a temporary difference in deferred tax accounting?
A temporary difference is a difference between the carrying amount of an asset or liability in a company's financial statements and its tax base. These differences will reverse in future periods, leading to either taxable or deductible amounts.
Why does a company recognize a deferred tax asset?
A company recognizes a deferred tax asset to account for the future tax benefits it expects to receive. This often happens when expenses are recognized earlier for financial reporting than for tax purposes, or when there are accumulated net operating losses (NOLs) or tax credits that can reduce future tax payments.
How does a net operating loss (NOL) relate to a deferred tax asset?
When a company incurs a net operating loss (meaning its deductible expenses exceed its income for tax purposes), tax laws often allow this loss to be carried forward to offset future taxable income. This future reduction in taxes creates a deferred tax asset.
What is a valuation allowance, and why is it important for a deferred tax asset?
A valuation allowance is a reserve account used to reduce the reported value of a deferred tax asset. It is established if it is deemed "more likely than not" that some or all of the deferred tax asset will not be realized because the company may not generate enough future taxable income to utilize the tax benefit. It is an important indicator of management's confidence in future profitability.
Is a deferred tax asset a real cash asset?
No, a deferred tax asset is not a cash asset. It represents a non-cash accounting adjustment that reflects a future reduction in tax payments. The actual cash benefit will only be realized when the company generates sufficient future taxable income to utilize the deferred tax asset.