Deferred_tax_assets

What Is Deferred Tax Assets?

A deferred tax asset (DTA) represents the amount of income tax an entity has overpaid or paid in advance, or the tax savings it expects to realize in the future. It arises due to temporary differences between accounting profit (reported in financial statements) and taxable income, or from the carryforward of unused tax losses and tax credits. Deferred tax assets fall under the broader financial category of Accounting and Taxation, specifically related to the complexities of interperiod tax allocation. Essentially, DTAs reflect a future tax benefit, allowing a company to reduce its tax payments in subsequent periods.

History and Origin

The concept of accounting for income taxes, including the recognition of deferred tax assets and liabilities, evolved to address the discrepancies that arise when financial reporting standards diverge from tax laws. Historically, simpler cash-based accounting methods did not fully capture the future tax implications of current transactions. The move towards more comprehensive accrual accounting highlighted the need to recognize tax effects when the underlying transactions occur, not just when cash changes hands. Early pronouncements by accounting bodies, such as Accounting Principles Board (APB) Opinion No. 11 in 1967 in the U.S. and later Financial Accounting Standards Board (FASB) Statement No. 96 (and its subsequent replacement, Statement No. 109), laid the groundwork for modern deferred tax accounting. The International Accounting Standards Board (IASB) also addressed this through IAS 12 Income Taxes, which was originally issued by the International Accounting Standards Committee in October 1996 and adopted by the IASB in April 2001.⁶ This standard requires the recognition of deferred tax assets for deductible temporary differences and unused tax losses or credits, subject to certain conditions.⁵

Key Takeaways

• A deferred tax asset represents a future tax saving for a company.
• It originates from temporary differences between financial accounting rules and tax regulations, or from unutilized tax losses and credits.
• Deferred tax assets are recognized on the balance sheet and signify an amount recoverable from tax authorities or a reduction in future tax payments.
• Their recognition often requires management judgment regarding the probability of future taxable profits.
• A valuation allowance may be recorded against deferred tax assets if it is unlikely that the company will realize the full tax benefit.

Formula and Calculation

The calculation of deferred tax assets primarily involves identifying and quantifying temporary differences and then applying the enacted tax rate.

The general concept can be expressed as:

Where:

• Deductible Temporary Differences: These are differences between the carrying amount of an asset or liability in the financial statements and its tax base. They result in amounts that are deductible in determining taxable profit of future periods when the carrying amount of the asset or liability is recovered or settled.
• Unused Tax Losses: Often referred to as a net operating loss (NOL) carryforward, these are past losses that can be used to offset future taxable income. The IRS provides guidance on how to calculate and use NOLs in publications such as IRS Publication 536.⁴
• Unused Tax Credits: These are tax credits from prior periods that have not yet been utilized to reduce tax liabilities.
• Future Enacted Tax Rates: The tax rates that are expected to apply when the temporary differences reverse or the losses/credits are utilized.

Interpreting the Deferred Tax Assets

The presence of deferred tax assets on a company's balance sheet can be interpreted as an indication of future tax savings. However, their significance and value are contingent on the company's ability to generate sufficient future taxable profits against which these assets can be utilized. For instance, if a company has significant net operating losses from prior periods, these losses give rise to deferred tax assets because they can be used to reduce tax obligations on future profits.

Analysts often assess the sustainability and probability of realizing deferred tax assets. A large DTA, particularly one stemming from significant past losses, might raise questions about the company's profitability outlook. Conversely, a DTA arising from timing differences (e.g., accelerated depreciation for tax purposes) indicates a healthier, profitable entity merely benefiting from different accounting timelines. Under IFRS, deferred tax assets are recognized only to the extent that it is probable that sufficient taxable profit will be available against which the deductible temporary difference can be utilized.³

Hypothetical Example

Consider "Tech Solutions Inc.," a company that invested heavily in research and development (R&D) in its early years, resulting in a significant net operating loss of $1,000,000 in Year 1. For accounting purposes, these R&D expenses were recognized immediately, contributing to the loss. For tax purposes, however, certain R&D costs could be amortized over several years, or the company might have other deductible temporary differences.

Assuming a corporate tax rate of 25%, Tech Solutions Inc. would record a deferred tax asset of $250,000 ($1,000,000 x 25%) on its balance sheet at the end of Year 1. This deferred tax asset represents the future tax benefit the company expects to receive when it generates sufficient taxable income in subsequent years to offset this loss.

In Year 2, Tech Solutions Inc. becomes profitable, reporting a taxable income of $300,000. It can now utilize a portion of its net operating loss carryforward from Year 1 to reduce its current tax liability. The company would reduce its deferred tax asset by $75,000 ($300,000 x 25%) and recognize a corresponding reduction in its tax expense on the income statement. The remaining DTA of $175,000 would carry forward to future periods.

Practical Applications

Deferred tax assets play a crucial role in various aspects of financial analysis, regulation, and corporate planning.

• Financial Reporting and Analysis: Deferred tax assets are presented on a company's balance sheet under GAAP and IFRS, providing insights into future tax consequences of current operations. Analysts scrutinize these assets to understand their nature (e.g., from losses vs. timing differences) and the likelihood of their realization.
• Mergers and Acquisitions: In M&A deals, the existence and transferability of a target company's deferred tax assets can be a significant factor, as they represent a potential source of future tax savings for the acquiring entity. However, rules exist to limit the use of such assets after ownership changes.
• Regulatory Scrutiny: Regulators, such as the Securities and Exchange Commission (SEC) in the U.S., monitor the accounting for deferred tax assets to ensure proper recognition and disclosure. For instance, SEC Staff Accounting Bulletin (SAB) 107 provides guidance on accounting for income tax effects related to share-based payment arrangements, which can give rise to deferred tax assets.²
• Tax Planning: Companies use deferred tax assets as part of their broader tax planning strategies, aiming to optimize their tax position over time by leveraging available carryforwards and deductible differences.

Limitations and Criticisms

While deferred tax assets offer a clear indication of potential future tax benefits, their recognition and valuation are subject to certain limitations and criticisms:

• Uncertainty of Realization: The primary criticism revolves around the uncertainty of realizing the future tax benefit. Deferred tax assets are only valuable if the company generates sufficient future taxable profits. If a company continues to incur losses, or if tax laws change, the DTA may never be fully utilized, leading to write-downs. Accounting standards require a valuation allowance to be established if it is more likely than not that some portion or all of a deferred tax asset will not be realized.
• Subjectivity in Estimation: Estimating future taxable income, which is crucial for recognizing and valuing deferred tax assets, involves significant management judgment and can be highly subjective. This can introduce a degree of estimation uncertainty into the financial statements.
• Impact of Tax Law Changes: Changes in corporate tax rates or tax legislation can significantly impact the value of existing deferred tax assets, requiring immediate adjustments. A reduction in the corporate tax rate, for example, would decrease the future tax savings associated with a given DTA.
• Complexity: The accounting for income taxes is notoriously complex, leading to potential errors and misinterpretations. This complexity can make it challenging for external users to fully understand and assess the true value of deferred tax assets. The Financial Reporting Council (FRC) in the UK has conducted thematic reviews on deferred tax assets, highlighting common issues in their recognition and disclosure by companies.¹

Deferred Tax Assets vs. Deferred Tax Liabilities

The primary distinction between deferred tax assets and deferred tax liabilities lies in their nature as future tax implications.

Both deferred tax assets and deferred tax liabilities result from temporary differences between the tax rules and the accrual accounting principles used for financial reporting. They represent the timing difference in when income or expense is recognized for financial reporting versus tax purposes.

FAQs

What causes a deferred tax asset?

A deferred tax asset primarily arises when a company has paid more taxes than it currently owes based on its financial statements, or when it has overpaid taxes in prior periods, or when it has future tax benefits from events like net operating losses or tax credits. These are often due to differences in timing of revenue and expense recognition between tax laws and financial accounting standards.

How is a deferred tax asset recognized on financial statements?

A deferred tax asset is recorded on a company's balance sheet as a non-current asset. Its value is determined by multiplying the deductible temporary differences, unused tax losses, and unused tax credits by the enacted future tax rates.

Can a deferred tax asset expire?

Yes, certain components of a deferred tax asset, particularly net operating loss carryforwards and some tax credits, may have expiration dates under specific tax laws. If a company does not generate sufficient taxable income before these expiration dates, the deferred tax asset may expire unused, necessitating a write-off. However, recent tax law changes in some jurisdictions have allowed for indefinite carryforwards of certain losses.

What is a valuation allowance for deferred tax assets?

A valuation allowance is a contra-asset account used to reduce a deferred tax asset to the amount that is more likely than not to be realized. If a company determines that it is unlikely to generate enough future taxable income to fully utilize its deferred tax assets, it will establish a valuation allowance, effectively reducing the carrying value of the DTA on its financial statements.