Deferred Tax Asset: What It Is and How to Calculate and Use It, With Examples

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Deferred Tax Asset: What It Is and How to Calculate and Use It, With Examples

What Is a Deferred Tax Asset?

A deferred tax asset is a balance-sheet item that decreases a company’s taxable income in the future.

A line item asset like this might be discovered when a company overpays its taxes. This money will ultimately be refunded to the company as tax relief. As a result, the excess payment becomes an asset to the organization.

A deferred tax asset is the inverse of a deferred tax liability, which represents a predicted rise in a company’s income tax obligation.

Key Takeaways

  • A deferred tax asset is a balance-sheet item that emerges from an overpayment or early payment of taxes.
  • It is the inverse of a deferred tax obligation, which reflects unpaid income taxes.
  • When there are disparities in tax regulations and accounting standards, or when there is a rollover of tax losses, a deferred tax asset might exist.
  • Most businesses may carry over a deferred tax asset forever beginning in 2018.

Understanding Deferred Tax Assets

When taxes are paid or carried forward but cannot yet be recorded on the income statement, a deferred tax asset is commonly established.

Deferred tax assets may be established, for example, when tax authorities recognize income or costs at separate dates than the firm does as an accounting norm.

These assets contribute to the reduction of the company’s future tax obligation.

It should be noted that a deferred tax asset is recorded only when the difference between the asset’s loss-value and depreciation is projected to offset its future profit.

A deferred tax asset is similar to pre-paid rent or a refundable insurance payment. While the company no longer has cash on hand, it still has similar value, which must be recorded in its financial accounts.

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Common Deferred Tax Assets

The carryover of losses is a simple example of a deferred tax asset. If a company makes a loss during a fiscal year, it may normally utilize that loss to reduce its taxable income in subsequent years. In this sense, the loss is a benefit.

Another possibility occurs when there is a discrepancy between accounting and tax standards. Deferred taxes arise, for example, when costs are recognized in a company’s income statement before they are needed by tax authorities, or when revenue is subject to taxes before it is taxable in the income statement.

Essentially, if the tax base or tax regulations for assets and/or liabilities alter, the option to create a deferred tax asset exists.

Example of Deferred Tax Asset Calculation

Image by Sabrina Jiang © Investopedia2020

Assume a computer manufacturing business forecasts that 2% of total output will be returned for warranty repairs in the following year based on prior history. If the company’s total revenue in year one is $3,000 and its warranty expense is $60 (2% x $3,000), the taxable income is $2,940.

However, most tax authorities do not allow businesses to deduct expenditures based on predicted warranties, so the business must pay taxes on the whole $3,000.

If the company’s tax rate is 30%, the difference of $18 ($60 x 30%) between taxes due in the income statement and taxes paid to the tax authorities is a deferred tax asset.

Special Considerations

Consider the following fundamental aspects of deferred tax assets. For starters, beginning with the 2018 tax year, they may be carried forward forever for most businesses but cannot be carried back.

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The second factor to evaluate is the impact of tax rates on the value of deferred tax assets. If the tax rate rises, the corporation benefits since the asset values rise as well, offering a greater cushion for a higher income. However, when the tax rate falls, so does the value of the tax asset. This implies that the corporation may not be able to utilize the whole benefit before it expires.

Why Do Deferred Tax Assets Occur?

If a company has prepaid its taxes, it may have a deferred tax asset on its balance sheet.

This might simply be due to a time gap between when a firm pays its taxes and when the tax authorities credits it. It might also suggest that the corporation overpaid its taxes. The money will be returned in such instance.

In such circumstances, the company’s accounts must show taxes paid or money owed to it.

Do Deferred Tax Assets Carry Forward?

Yes. Beginning in 2018, taxpayers will be able to carry forward deferred tax assets forever.

What Is a Deferred Tax Asset vs. a Deferred Tax Liability?

A deferred tax asset is a financial advantage, while a deferred tax liability is a future tax obligation or payment that must be made.

Traditional 401(k) plan participants, for example, contribute to their accounts with pre-tax income. Income tax is required on the contributions when they are finally withdrawn. That is a tax burden that has been delayed.

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