Deferred Tax Assets

Updated on January 2, 2024
Article byWallstreetmojo Team
Edited byAshish Kumar Srivastav
Reviewed byDheeraj Vaidya, CFA, FRM

What are Deferred Tax Assets?

A deferred tax asset is an asset to the Company that usually arises when the Company has overpaid taxes or paid advance tax. Such taxes are recorded as an asset on the balance sheet and are eventually paid back to the Company or deducted from future taxes.

These are created because of the timing difference between the book and taxable profits. Some items can be deducted, and others are not deducted from the taxable profits.

Deferred Tax Assets 1

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Deferred Tax Asset Examples

Let us discuss some of the reasons with examples given below:

# 1 – Business Loss

The simplest method of creating these tax assets is when the business incurs a loss. The Company’s loss can be carried forward and set off against the profits of the subsequent years, thus reducing tax liability. Hence, such a loss is an asset or deferred tax asset, to be precise, for the Company.

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Deferred Tax Assets Video Explanation

#2 – Differences in the Depreciation Method in Accounting and Tax Purpose

Due to differences in the methods used for depreciation in accountingDepreciation In AccountingDepreciation is a systematic allocation method used to account for the costs of any physical or tangible asset throughout its useful life. Its value indicates how much of an asset’s worth has been utilized. Depreciation enables companies to generate revenue from their assets while only charging a fraction of the cost of the asset in use each year. read more and tax purposes. There are two methods of depreciation – straight line methodStraight Line MethodStraight Line Depreciation Method is one of the most popular methods of depreciation where the asset uniformly depreciates over its useful life and the cost of the asset is evenly spread over its useful and functional life. read more and the double depreciation method. In the double depreciation methodDouble Depreciation MethodIn declining balance method of depreciation or reducing balance method, assets are depreciated at a higher rate in the initial years than in the subsequent years. A constant depreciation rate is applied to an asset’s book value each year, heading towards accelerated depreciation.read more, the depreciation expenses are more in the initial periods. If this method is used for accounting purposes, whereas a straight-line method is used for tax purposes, the Company will pay more tax than shown in its books. Thus, it will record deferred tax assets on the balance sheetBalance SheetA balance sheet is one of the financial statements of a company that presents the shareholders' equity, liabilities, and assets of the company at a specific point in time. It is based on the accounting equation that states that the sum of the total liabilities and the owner's capital equals the total assets of the company.read more.

#3 – Differences in Depreciation Rate in Accounting and Tax Purpose

The depreciation method and the depreciation rate could cause an occurrence of this tax asset. For example, if a depreciation rate of 20% is used for tax purposes while a rate of 15% is used for accounting purposes, it will create a difference in actual tax paid and tax on the Income statementIncome StatementThe income statement is one of the company's financial reports that summarizes all of the company's revenues and expenses over time in order to determine the company's profit or loss and measure its business activity over time based on user requirements.read more. Thus, the Company will record deferred tax assets (DTA) on the balance sheet.

Suppose taxable income is $ 5000. Thus, the tax will be $ 750 on the income statement and $ 1000 paid to the tax authorities. Hence, there will be a DTA of (1000 – 750 = $ 250) due toThe depreciation rate is the percent rate at which an asset depreciates during its estimated useful life. It can also be defined as the percentage of a company's long-term investment in an asset that the firm claims as a tax-deductible expense throughout the asset's useful life.read more depreciation ratesDepreciation RatesThe depreciation rate is the percent rate at which an asset depreciates during its estimated useful life. It can also be defined as the percentage of a company's long-term investment in an asset that the firm claims as a tax-deductible expense throughout the asset's useful life.read more.

In the above two examples, i.e., deferred tax assets arise due to depreciation andTax Loss Carry forward is a provision which permits an individual to take forward or carry over the tax loss to the next year to set off the future profit. Any taxpayer can claim it to lower the tax payments in the future.read more carry forward lossesCarry Forward LossesTax Loss Carry forward is a provision which permits an individual to take forward or carry over the tax loss to the next year to set off the future profit. Any taxpayer can claim it to lower the tax payments in the future.read more. This asset is recorded only if it can materialize in future incomes. The Company checks and prepares a projection of future income statements and balance sheets. And if the Company feels that it can be used, it is only recorded on DTA in the balance sheet. If the Company feels that this asset cannot materialize in the future with certainty in a certain period, it will write offWrite OffWrite off is the reduction in the value of the assets that were present in the books of accounts of the company on a particular period of time and are recorded as the accounting expense against the payment not received or the losses on the assets.read more any such entry in the balance sheet.

#4 – Expenses

Deferred tax assets can also form when expenses are recognized in the income statement before they are recognized in the tax statement and to tax authorities. For example, some legal expenses are not considered and thus not deducted immediately from the tax statement; however, they are shown as the expense in the income statement.

Thus, for income statement

Revenue$5,000
Expenses$1,500
Legal Expenses$500
Taxable Income$3,000
Tax (@ 30%)$900

Thus, for tax statement

Revenue$5,000
Expenses$1,500
Legal Expenses$500
Taxable Income$3,500
Tax (@ 30%)$1,050

There is a difference in tax payable in the income and tax statements. Thus, a DTA of (1050 -900) = $ 150 will be shown on the balance sheet.

#5 – Revenues

Sometimes revenue is recognized in one period for tax purposes and in a different period for accounting purposes. If the revenue is recognized for tax purposes before it is done in accounting, the Company will pay tax on such high revenue, thus creating this tax asset.

#6 – Warranties

Warranties are one of the most common examples.

Let us say an electrical goods Company has a revenueRevenueRevenue is the amount of money that a business can earn in its normal course of business by selling its goods and services. In the case of the federal government, it refers to the total amount of income generated from taxes, which remains unfiltered from any deductions.read more of $5 million and expenses of $3 million, thus a profit of $2 million. However, the expenses are bifurcated as $2.5 million for the cost of goods soldCost Of Goods SoldThe Cost of Goods Sold (COGS) is the cumulative total of direct costs incurred for the goods or services sold, including direct expenses like raw material, direct labour cost and other direct costs. However, it excludes all the indirect expenses incurred by the company. read more, general expenses, etc., and $0.5 million for future warranties and returns.

The tax authorities do not consider future warranties and returns as an expense. It is because this expense has not been incurred but only accounted for. Therefore, the Company cannot deduct such an expense while calculating taxes; thus, it pays tax on $0.5 million. Therefore, this amount will be part of the deferred tax assets on the balance sheet.

#7 – Bad Debts

Another example of Deferred tax assets is Bad Debt. Let’s assume that a company has a book profit of $10,000 for a financial year, including a provision of $500 as bad debt. However, this bad debt is not considered for taxes until it has been written off. Thus, the Company will have to pay tax on $10,500, creating this tax asset.

If the tax rate is 30%, the Company will make a deferred tax asset journal entryDeferred Tax Asset Journal EntryThe excess tax paid is known as deferred tax asset and its journal entry is created when there is a difference between taxable income and accounting income. The journal entry for deferred tax asset is: Current Tax Expense Dr. To Deferred tax liability To Income tax liability. read more in its book for $150.

Conclusion

Deferred tax assets in the balance sheet line item on the non-current assets are recorded whenever the Company pays more tax. The amount under this asset is then utilized to reduce future tax liability. The difference in the deferred tax calculation of book profits and tax profits may lead to the recording of deferred tax assets. It can be caused for many reasons because certain items are allowed/disallowed in the tax income statement than in the accounting income statement.

To summarize: This is created whenever the book profitBook ProfitBook Profit is the profit amount that a business earns from its operations & activities but has not been realized yet. It is not tracked by analysts or stakeholders & its calculation is relevant only to evaluate a Company’s tax liability. read more is lower than the taxable profit, which causes the Company to pay a higher tax now and lesser tax in the future.

This article has been a guide to Deferred Tax Assets. Here we discuss the Top 7 examples & calculations of Deferred tax assets, including business loss, warranties, bad debts, expenses, depreciation method, depreciation rates, etc. You can learn more about accounting from the following articles –

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