When it comes to taxes, most individuals and businesses despise writing a check to the IRS. However, there are certain situations when excellent financial planning can lead to a thing called a deferred tax asset. This asset is like a little pot of gold at the end of the rainbow that can help offset future tax liabilities.
A deferred tax asset is created when a company’s tax liability in the future is expected to be lower than its present tax liability. This can happen when a business has previously paid more taxes than its obligation and can carry forward the excess amount as a credit to reduce future tax liabilities. Companies may also experience deferred tax assets from tax deductions that can only be applied in future tax returns. When a company sees the deferred tax asset as a possible advantage, it must properly account for it and report it on its financial statements to prepare for future tax liabilities.
While understanding tax laws and guidelines can be complex, deferring taxes can be a powerful tool in reducing future tax liabilities. A well-planned and structured deferred tax asset can provide businesses with a strategic advantage and creating that advantage requires careful analysis and strategic planning. By anticipating future tax liabilities and taking the necessary steps to offset those liabilities through the creation of a deferred tax asset, businesses can stay one step ahead and maintain their competitive advantage in a constantly changing market.
Definition of Deferred Tax Asset
A deferred tax asset is a type of asset that arises due to the difference between the tax expense recognized in the financial statements and the actual tax liability that will be paid to the government. Specifically, it arises when the taxable income of an organization is less than the income stated in the financial statements. In such situations, the tax authorities may allow the organization to carry forward the difference between the two amounts as a deferred tax asset, which can be used to offset future tax liabilities.
Deferred tax assets can be created due to various reasons, including:
- Temporary differences in the timing of recognition of revenue and expenses between financial statements and tax returns
- Tax loss carryforwards from prior periods that can be used to offset future taxable income
- Unused tax credits that can be carried forward to future periods
It’s important to note that deferred tax assets can only be recognized when it’s more likely than not that they will be realized in the future. This means that the organization must have sufficient future taxable income against which the deferred tax asset can be offset. If it’s not more likely than not that the deferred tax asset will be realized, the organization must reduce its value in the financial statements.
Examples of Deferred Tax Asset
A deferred tax asset arises when a company has overpaid its taxes or paid taxes in advance in the current year, which results in a reduction of tax payments in the future. In other words, it is a tax reduction that a company will benefit from in the future.
Here are some common examples of deferred tax assets:
- Depreciation: Companies get tax deductions for depreciating their assets over time, but the deductions may not match the actual decline in value of assets. This results in the creation of a deferred tax asset where the company is allowed to defer taxes it paid when the asset was worth more than the claimed depreciation.
- Bad debts: Businesses get a tax break for writing off bad debts that they can’t recover. This can result in a deferred tax asset as companies write off more bad debts than they would for accounting purposes.
- Losses: Companies can also have deferred tax assets if they have incurred losses in the past that are allowed to be carried forward for tax purposes. This means that a company can reduce its taxes in future years by applying the losses against its profits.
Although deferred tax assets represent a future tax reduction for a company, there is a risk that these assets might become worthless if the company fails to produce enough taxable income to use them up. In such a situation, the deferred tax asset may require a write-down that can result in a significant impact on the financial statements.
Deferred Tax Asset Disclosure
Companies are required to disclose their deferred tax assets on their financial statements. The disclosure should include details of the following:
- The amount of the deferred tax asset
- The related tax rate
- The nature of the temporary difference giving rise to the deferred tax asset
- The expiration dates, if any, for the tax benefits that relate to the deferred tax asset
Additionally, companies should also include a discussion of their expectations regarding future taxable income and how it relates to the deferred tax assets. This will give investors an idea of the company’s ability to realize the benefits of the deferred tax asset in the future.
| Deferred Tax Asset Disclosure | Description |
|---|---|
| Amount of deferred tax asset | The dollar value of the deferred tax asset on the balance sheet |
| Related tax rate | The tax rate that will be applied to the deferred tax asset when it is realized |
| Temporary difference | The difference between the book value and tax value of an asset or liability |
| Expiration dates | The date by which the deferred tax asset must be utilized or it expires |
By providing detailed disclosure of deferred tax assets, companies can help investors gain a better understanding of their financial statements and their potential tax liabilities. This can help investors make more informed decisions regarding their investments in the company.
Criteria for recognizing deferred tax asset
Deferred tax assets can arise when a company pays more taxes than it owes in the current year and can use the excess to offset future tax liabilities. Recognizing deferred tax assets can be a complex process and requires meeting specific criteria, including:
- The company must have a history of profitability, and it is reasonable to expect continued profitability in the future.
- The company must have taxable income in future years when it can use the deferred tax asset to offset tax liability.
- The company must meet certain legal requirements, such as carryforward limitations set by tax laws.
While recognizing deferred tax assets may seem like an obvious way to reduce taxes in the future, it is crucial to ensure that the criteria are met before doing so. Not meeting these criteria can result in financial statement misstatements and may even lead to audit issues.
Deferred tax assets can also be affected by changes in tax rates or laws, which can impact the company’s ability to fully utilize the asset. Therefore, it is important to regularly reassess deferred tax assets and to adjust estimates as necessary to reflect changes in the business environment.
Another factor to consider when recognizing deferred tax assets is the potential impact on financial ratios. Generally accepted accounting principles (GAAP) require that deferred tax assets are recorded as an asset on the balance sheet, but this can lead to inflated asset values and affect financial ratios that rely on asset values, such as return on assets (ROA).
| Impact on Financial Ratios: | Example: |
|---|---|
| Return on Assets (ROA) | ROA is artificially increased due to inflated asset values caused by deferred tax assets. |
| Earnings Per Share (EPS) | EPS is increased because deferred tax assets increase net income without any real cash inflows. |
| Debt to Equity Ratio | Deferred tax assets may artificially lower the company’s debt to equity ratio if they are included in equity calculations. |
Therefore, companies must carefully consider the impact of deferred tax assets on financial ratios and disclose them transparently in financial statements to ensure that investors and other stakeholders are aware of any potential distortions.
Types of Temporary Differences Leading to Deferred Tax Asset
A deferred tax asset arises due to the temporary differences between the book value and the tax basis of assets and liabilities. In other words, it represents the reduction in taxes that the company will pay when the asset is realized or the liability is settled in the future. Here are the various types of temporary differences that can lead to deferred tax asset:
- Depreciation Expense: When a company uses accelerated depreciation for tax purposes, the depreciation expense will be higher than the book value. This creates a temporary difference and results in a deferred tax asset.
- Revenue Recognition: When a company recognizes revenue before receiving payment, the tax basis will be lower than the book value, resulting in a deferred tax asset.
- Loss Carryforwards: If a company incurs a net operating loss, they can carry it forward to reduce taxes in future years, resulting in a deferred tax asset.
- Deferred Revenue: When a company receives payment before providing goods or services, the tax basis will be higher than the book value, resulting in a deferred tax asset.
- Bad Debt Expense: When a company writes off bad debts for tax purposes, the tax basis will be higher than the book value, resulting in a deferred tax asset.
Example of Calculation for Deferred Tax Asset
Assume a company has a depreciation expense of $100,000 for the year for book purposes, and $120,000 for tax purposes. This results in a $20,000 temporary difference, which can be used to calculate the deferred tax asset.
| Book Value | Tax Basis | Temporary Difference |
|---|---|---|
| $100,000 | $120,000 | $20,000 |
If the tax rate is 30%, the deferred tax asset would be $6,000 ($20,000 x 30%). When the company realizes the asset in the future, the deferred tax asset will reduce the taxes owed, resulting in a lower tax expense.
How to Calculate Deferred Tax Asset
Deferred tax assets are created when a company records an expense on its financial statements that it can use to offset future tax liabilities. In other words, a deferred tax asset is an asset that can be used to reduce the amount of taxes a company owes in the future. Calculating a deferred tax asset involves a few key steps:
- Calculate the difference between the book value and the tax value of an asset or liability. This is known as the temporary difference.
- Multiply the temporary difference by the tax rate. This will give you the amount of tax savings that will be realized in the future.
- Determine the probability that the company will be able to use the deferred tax asset in the future. If it is less than 50%, the deferred tax asset should be reduced or eliminated.
Let’s walk through an example:
Company A has a piece of equipment that it purchased for $100,000. The equipment has a tax life of 10 years and is being depreciated on a straight-line basis. The tax rate is 30%. The book value of the equipment is $50,000 and the tax value is $70,000. The difference between the two values is $20,000.
To calculate the deferred tax asset, we multiply the temporary difference by the tax rate:
$20,000 x 30% = $6,000
So, Company A has a potential deferred tax asset of $6,000. However, we need to determine the probability that the company will be able to use the deferred tax asset in the future. If the probability is less than 50%, the deferred tax asset should be reduced or eliminated.
In this case, if Company A has a history of being profitable and generating taxable income, it’s likely that it will be able to use the deferred tax asset in the future. However, if the company has a history of losing money or generating little to no taxable income, it’s unlikely that it will be able to use the deferred tax asset.
Summary
| Step | Calculation | Importance |
|---|---|---|
| Calculate temporary difference | Book value minus tax value | Identifies potential deferred tax asset |
| Multiply by tax rate | Temporary difference times tax rate | Determines size of deferred tax asset |
| Determine probability of use | Review company’s profitability and tax history | Eliminates unlikely deferred tax assets |
By following these steps, you can calculate your company’s deferred tax assets and determine the probability that they will be used in the future. This can help you determine the true value of your company’s assets and plan for future tax liabilities.
Impact of changes in tax laws on deferred tax asset
Deferred tax assets are created by timing differences between the recognition of taxable income and the recognition of tax expense on financial statements. These assets represent future tax benefits that can be used to offset future taxable income. However, changes in tax laws can have a significant impact on the value of deferred tax assets.
- Changes in tax rates: When tax rates change, the value of deferred tax assets can also change. For example, if the tax rate decreases, the value of deferred tax assets will also decrease because the future tax benefits will be worth less.
- Changes in tax deductions: Tax deductions can have a significant impact on the value of deferred tax assets. If a deduction is eliminated or reduced, the value of deferred tax assets related to that deduction will decrease.
- Changes in tax credits: Tax credits can also impact the value of deferred tax assets. If a tax credit is eliminated or reduced, the value of deferred tax assets related to that credit will decrease.
Furthermore, changes in tax laws can also affect the timing of when deferred tax assets can be realized. For example, some tax laws may require deferred tax assets to be used within a certain timeframe. If that timeframe is shortened or eliminated, the value of deferred tax assets can decrease.
To better understand the impact of changes in tax laws on deferred tax assets, consider the following table:
| Tax Law Change | Impact on Deferred Tax Asset |
|---|---|
| Tax rate decreases | Decrease |
| Tax rate increases | Increase |
| Deduction eliminated | Decrease |
| Deduction reduced | Decrease |
| Credit eliminated | Decrease |
| Credit reduced | Decrease |
| Timeframe shortened | Decrease |
It is important for companies to monitor changes in tax laws and determine the potential impact on their deferred tax assets. By doing so, companies can adjust their financial statements and avoid any negative impact on their overall financial position.
Accounting treatment for deferred tax asset
A deferred tax asset (DTA) represents taxes that have been paid or recorded as an expense in the current period but won’t be recognized as a tax deduction until a future period, due to the timing differences between the tax and accounting rules. The accounting treatment for deferred tax asset varies depending on whether the company believes that the deferred tax asset is realizable or not.
If there is a reasonable certainty that the deferred tax asset will be realized, the asset must be recorded on the company’s balance sheet and an income tax benefit reported in the income statement. If the deferred tax asset is not realizable, the company must establish a valuation allowance to reduce the carrying value of the deferred tax asset to the amount that is more likely than not to be realized.
Factors contributing to the realization of a deferred tax asset
- The company has a history of taxable income in prior years and expects to generate future taxable income in the future
- The company has tax planning strategies that allow for the realization of the deferred tax asset
- The company has tax law changes that will allow for the realization of the deferred tax asset
- The company has sufficient taxable income to offset the deferred tax asset
- The company is profitable and expects to have a positive cash flow in the future
- The company has sufficient inventory and other assets to support the future taxable income
- The company has long-term contracts that will generate taxable income in the future
Valuation allowances for deferred tax assets
If it is more likely than not that some portion or the entire deferred tax asset will not be realized, then a valuation allowance must be recorded to reduce the carrying value of the asset. A valuation allowance is a contra-asset, meaning that it reduces the value of another asset, in this case, the DTA. Valuation allowances must be reviewed at the end of each reporting period, and if circumstances change and the deferred tax asset becomes realizable, then the valuation allowance can be reversed.
Companies can use different methods to calculate the necessary valuation allowance for deferred tax assets, including the specific identification method, allowance by percentage, or a probability-weighted method. The most common valuation method is the probability-weighted method, which considers all available evidence, both positive and negative, to assess whether the deferred tax asset is more likely than not to be realized.
Conclusion
| Deferred tax asset treatment | Realizable | Not Realizable |
|---|---|---|
| Accounting treatment | Record on balance sheet, recognize an income tax benefit in income statement | Establish a valuation allowance to reduce carrying value of the DTA |
| Valuation method | N/A | Specific identification, allowance by percentage, probability-weighted method |
The accounting treatment for deferred tax assets is critical to ensure accurate financial reporting. A company must assess whether or not the asset is realizable and record a valuation allowance if it is not. Proper evaluation of a deferred tax asset can help investors and analysts better understand the company’s ability to generate future cash flows and profitability.
FAQs: What Causes a Deferred Tax Asset?
1. What is a deferred tax asset?
A deferred tax asset is an accounting term used to describe a tax break that a company expects to receive in the future, due to temporary differences in financial reporting and tax accounting rules.
2. What causes a deferred tax asset?
There are many different factors that can lead to a deferred tax asset, including depreciation, losses carried forward, and deferred revenue recognition.
3. How do deferred tax assets affect a company’s financial statements?
Deferred tax assets can have a significant impact on a company’s financial statements, as they represent a reduction in the amount of taxes the company will owe in the future. This can help lower overall tax expenses and increase net income.
4. How are deferred tax assets calculated?
Deferred tax assets are calculated based on the difference between a company’s accounting methods and tax methods. This is typically done by comparing net income on the financial statement to taxable income on the tax return.
5. Are deferred tax assets always a good thing?
While deferred tax assets can be beneficial for companies, they can also become a liability if the company is unable to realize the full benefit. This can happen if the company is not able to generate enough future income to use the full tax break.
6. How can companies maximize the benefits of deferred tax assets?
Companies can maximize the benefits of deferred tax assets by focusing on growth strategies that will generate more income in the future. This can include expanding into new markets, bringing on new customers, and investing in new technologies.
Closing Thoughts
Thank you for reading our article on what causes a deferred tax asset. We hope you found this information helpful and informative. If you have any further questions or comments, please don’t hesitate to contact us. And be sure to check back soon for more informative articles!