What is a deferred tax asset?
A deferred tax asset is an asset on the balance sheet of a business that can be used to reduce its taxable income. This can be a situation where a business has overpaid taxes or prepaid taxes on its balance sheet. These taxes are eventually returned to the company in the form of tax breaks, and the overpayment is therefore an asset for the company.
Deferred tax assets
How does a deferred tax asset work?
Deferred tax assets are often created as a result of taxes paid or deferred but not yet recognized in the income statement. For example, deferred tax assets can be created by the fact that tax authorities recognize income or expense at times different from that of an accounting standard. This asset helps reduce the company’s future tax liability. It is important to note that a deferred tax asset is only recognized when the difference between the loss value or the depreciation of the asset should compensate for future profit.
A deferred tax asset can theoretically be compared to rent paid in advance or to reimbursable insurance premiums; although the business is run out of cash, it has comparable value, and this should be reflected in its financial statements.
A deferred tax asset is the opposite of a deferred tax liability, which can increase the amount of income tax owed by a business.
How Deferred Tax Assets Are Born
The simplest example of a deferred tax asset is loss carryforward. If a business experiences a loss in a fiscal year, it is generally allowed to use that loss to reduce its taxable income in subsequent years. In this sense, loss is an asset.
Another scenario where deferred tax assets arise is one where there is a difference between accounting rules and tax rules. For example, deferred taxes exist when expenses are recognized in the income statement before they are recognized by the tax authorities or when income is subject to tax before being taxable in the income statement. Essentially, whenever the tax base or the tax rules applicable to assets and / or liabilities are different, it is possible to create a deferred tax asset.
Practical example of calculating deferred tax assets
A computer manufacturing company estimates, based on its past experience, that the probability of a computer being returned for warranty repair in the next year is 2% of total production. If the total income of the business in the first year is $ 3,000 and the warranty costs in its books are $ 60 (2% x $ 3,000), the taxable income of the business is $ 2,940. However, most tax authorities do not allow companies to deduct their expenses based on the guarantees they expect. The business must therefore pay taxes on all of the $ 3,000.
If the corporation’s tax rate is 30%, the difference of $ 18 ($ 60 x 30%) between the taxes payable in the income statement and the actual taxes paid to the tax authorities is a deferred tax asset .
Important considerations for deferred tax assets
There are certain key characteristics of deferred tax assets to consider. First, they come with an expiration date if they are not exhausted. Most of the time, they expire after 20 years. The second thing to consider is how tax rates affect the value of deferred tax assets. If the tax rate goes up, it works in the business’s favor because the value of the assets also goes up, providing a bigger cushion for higher income. But if the tax rate goes down, the value of the tax asset also goes down. This means that the business may not be able to use the entire benefit before the expiration date.