Tax assets

What Are Tax Assets?

Tax assets, specifically referred to as deferred tax assets (DTAs), represent future tax benefits that a company expects to realize. These assets arise in financial accounting when taxes paid or carried forward exceed the amount of tax currently owed, often due to temporary differences between financial reporting income and taxable income. As part of a company's balance sheet within the broader category of Financial Accounting, tax assets indicate a reduction in future tax obligations. They are a crucial component of a company's financial statements, reflecting anticipated tax savings that will offset future profits.

History and Origin

The concept of accounting for income taxes, including the recognition of tax assets and liabilities, evolved significantly with the development of modern accounting standards. In the United States, the Financial Accounting Standards Board (FASB) established Statement of Financial Accounting Standards No. 109 (SFAS 109) in 1992, which was later codified into Accounting Standards Codification (ASC) 740, Income Taxes. This standard mandates a "balance sheet approach" to accounting for income taxes, requiring entities to recognize both current and deferred tax consequences of transactions and events.²⁶,²⁵

Internationally, the International Accounting Standards Committee (IASC), succeeded by the International Accounting Standards Board (IASB), introduced International Accounting Standard (IAS) 12, Income Taxes, in October 1996, effective for periods beginning on or after January 1, 1998.²⁴,²³ IAS 12 similarly adopts a balance sheet approach, requiring the recognition of deferred tax assets and deferred tax liabilities for temporary differences.²² These standards were developed to provide a comprehensive framework for how entities should account for income taxes, addressing timing differences between financial and tax reporting that give rise to tax assets and liabilities. The introduction of these detailed accounting requirements aimed to enhance the transparency and comparability of financial information related to income taxes across different entities and jurisdictions.²¹

Key Takeaways

• Tax assets, or deferred tax assets, represent future reductions in a company's tax burden.
• They primarily arise from temporary differences between financial accounting profit and taxable profit, or from net operating loss (NOL) and tax credits carryforwards.²⁰,¹⁹
• Tax assets are recognized on the balance sheet and are subject to a "probable profits" test under International Financial Reporting Standards (IFRS) and a "more likely than not" realization assessment under U.S. Generally Accepted Accounting Principles (GAAP).¹⁸,¹⁷
• Their value can fluctuate with changes in enacted or substantively enacted tax laws and rates.¹⁶,

Measurement and Recognition

The measurement and recognition of tax assets are guided by specific accounting principles aimed at reflecting the future tax benefits accurately. Under U.S. GAAP (ASC 740) and IFRS (IAS 12), the process involves identifying differences between the carrying amounts of assets and liabilities in the financial statements and their respective tax bases. These are known as temporary differences.¹⁵,¹⁴

For example, if a company recognizes an expense for accounting purposes that is not immediately deductible for tax purposes, this creates a deductible temporary difference. When this difference reverses in a future period, it will lead to a lower taxable income, thus creating a tax asset. Similarly, depreciation methods that differ between accounting and tax rules can create these differences.¹³

The general approach to measure deferred tax assets involves:

1. Identifying all deductible temporary differences and carryforwards (such as NOLs and tax credits).¹²
2. Multiplying these differences and carryforwards by the enacted or substantively enacted tax rates expected to apply when the tax asset is realized.¹¹,¹⁰

A critical aspect of recognizing tax assets is the assessment of realizability. Under U.S. GAAP, a valuation allowance is established if it is "more likely than not" that some portion or all of the deferred tax asset will not be realized. This assessment considers various factors, including future taxable income, reversals of deferred tax liabilities, and tax planning strategies.⁹ Similarly, under IFRS, a deferred tax asset is 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.⁸

Interpreting Tax Assets

Interpreting tax assets on a company's balance sheet requires understanding their contingent nature. Unlike cash or accounts receivable, a deferred tax asset does not represent an immediate influx of funds. Instead, it signifies a future reduction in the cash outflow for taxes.

Analysts and investors evaluate the amount of tax assets in relation to the company's projected future profitability. A large deferred tax asset, particularly one derived from significant net operating loss carryforwards, can be a positive indicator if the company is expected to return to profitability and utilize those losses to reduce future tax payments. Conversely, if there is doubt about a company's ability to generate sufficient future taxable income, a large valuation allowance against the tax asset may indicate significant uncertainty about its realizability. This assessment is vital for understanding the true financial health and future tax burden of an entity, influencing perceptions of its ability to manage its tax liabilities effectively.⁷

Hypothetical Example

Consider Tech Innovations Inc., a software company that invested heavily in research and development (R&D) during its startup phase, incurring significant expenses for financial reporting purposes. For the fiscal year, Tech Innovations reports a pre-tax accounting loss of $1,000,000. However, for tax purposes, some of its R&D expenses are capitalized and amortized over several years, meaning they are not immediately deductible in the current year.

Let's assume that due to these different accounting treatments, Tech Innovations' taxable income for the current year is actually a loss of only $500,000, while the remaining $500,000 of R&D expenses will be deductible in future periods. The corporate tax rate is 21%.

This $500,000 difference creates a deductible temporary difference. Tech Innovations would recognize a deferred tax asset calculated as:

This $105,000 represents a future tax benefit that Tech Innovations anticipates receiving when the R&D expenses become deductible for tax purposes in later years, reducing its future tax payments. This amount would be recorded as a non-current asset on the company's balance sheet.

Practical Applications

Tax assets play a significant role across various facets of financial analysis and corporate planning:

• Corporate Financial Planning: Companies utilize tax assets, especially those arising from net operating loss (NOL) carryforwards, in their strategic tax planning. The ability to offset future taxable income with past losses can significantly reduce a company's effective tax rate and improve its cash flow in profitable periods. This is particularly relevant for businesses emerging from periods of unprofitability.
• Mergers and Acquisitions (M&A): The existence and realizability of a target company's tax assets can be a significant factor in M&A valuations. An acquirer may benefit from the acquired company's NOLs or other tax attributes, using them to shelter its own future profits. Due diligence in M&A transactions often includes a thorough analysis of potential tax assets.
• Financial Statement Analysis: Investors and creditors scrutinize the deferred tax asset balance on the balance sheet to gain insights into a company's future tax obligations and its ability to generate sufficient taxable income to realize these benefits. The composition of tax assets, whether from tax credits, timing differences, or NOLs, provides further detail for analysis.⁶ The Internal Revenue Service (IRS) provides extensive guidance on various tax-related topics relevant to corporations in publications such as IRS Publication 17.
• Regulatory Compliance: Both U.S. GAAP (through ASC 740) and IFRS (through IAS 12) provide detailed rules for the recognition, measurement, and disclosure of tax assets. Adherence to these accounting standards ensures consistency and transparency in financial reporting. The guidance under ASC 740, for instance, details a multi-step approach for determining deferred tax asset balances.⁵

Limitations and Criticisms

Despite their importance, tax assets are subject to certain limitations and criticisms. A primary concern is their realizability. The value of a deferred tax asset is contingent upon the company generating sufficient future taxable income to utilize the underlying deductible temporary differences or carryforwards. If a company consistently reports losses, its ability to realize these assets diminishes, potentially leading to the need for a valuation allowance, which reduces the carrying amount of the deferred tax asset on the balance sheet.⁴ This assessment of future profitability involves significant judgment and estimation, introducing a degree of subjectivity into the financial statements.

Another criticism relates to the complexity of accounting for income taxes, which can make the interpretation of tax assets challenging for external users. Differences in tax laws across jurisdictions and the intricate nature of temporary differences can complicate the calculation and understanding of deferred tax balances. Academic research has highlighted that the accounting rules for deferred taxes can sometimes lead to unintended consequences, potentially affecting how investors evaluate these items.³ Furthermore, the indefinite leveraging of certain tax assets, especially since 2018 in the U.S., means their value can fluctuate with changes in statutory tax rates, adding another layer of variability. The inherent uncertainty surrounding future tax policy and economic conditions further underscores the challenges in precisely valuing and relying on deferred tax assets. Research from the National Bureau of Economic Research (NBER) has examined the significance and composition of deferred tax assets and liabilities, pointing out the substantial heterogeneity in positions across firms.²

Tax Assets vs. Deferred Tax Liabilities

Tax assets, or deferred tax assets, represent a future reduction in taxes payable. They arise when a company has paid more tax than is currently due, or when deductible expenses are recognized for accounting purposes before they are deductible for tax purposes. Conversely, deferred tax liabilities represent a future increase in taxes payable. These occur when taxable income is recognized for tax purposes before it is recognized for accounting purposes, such as accelerated depreciation for tax purposes compared to straight-line depreciation for financial reporting. The key distinction lies in whether the timing difference will result in a future tax benefit (asset) or a future tax obligation (liability). Both are critical components of a company's financial statements, providing insights into the timing differences between accounting profit and taxable profit.

FAQs

What causes tax assets to arise?

Tax assets primarily arise from temporary differences between how revenue and expenses are recognized for accounting purposes versus tax purposes. They can also result from net operating loss (NOL) carryforwards and unused tax credits.

Are tax assets guaranteed to be realized?

No, the realization of tax assets is not guaranteed. Companies must assess the likelihood of generating sufficient future taxable income to utilize these benefits. If it is not "more likely than not" (U.S. GAAP) or "probable" (IFRS) that the asset will be realized, a valuation allowance may be recorded to reduce its carrying value.

How do changes in tax rates affect tax assets?

Changes in enacted or substantively enacted tax laws and rates can impact the value of tax assets. If tax rates increase, the future tax benefit associated with the tax asset will generally increase, and vice-versa. The measurement of deferred taxes should reflect the tax rates expected to be applicable when the asset is realized.¹

Do all companies have tax assets?

Not all companies will have significant tax assets. Their existence depends on the specific timing differences, net operating losses, or tax credits that a company has accumulated. Companies that are consistently profitable and have fewer timing differences may have minimal or no tax assets.