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Deferred Tax Asset

Created when a company pays fewer taxes in the future due to decisions made today

What is a Deferred Tax Asset?

A deferred tax asset refers to an item on a company’s balance sheet that will reduce taxable income in the future due to the decisions made today. It occurs when a company overpays taxes or paid taxes in advance.

Deferred Tax Asset

Deferred tax assets are returned in the form of tax relief; thus, a deferred tax asset is considered an asset for the company. The opposite of deferred tax assets is deferred tax liability, which is an increase in the amount of future taxes paid by the company.

Summary

  • When taxes are overpaid or paid in advance, a deferred tax asset is created. A deferred tax asset is when a company pays fewer taxes in the future due to decisions made today.
  • Temporary difference is when there is a timing difference between the recognition of revenue and expenses between the accounting and tax authorities.
  • A deferred tax asset is documented when there is enough future profit to service the loss.

Understanding Deferred Tax Assets

Deferred tax assets are created when taxes are paid but are not yet recognized on the income statement. For example, a deferred tax asset arises due to timing differences between tax authorities recognizing an expense and revenue at different times than an accounting standard like the International Financial Reporting Standards (IFRS).

It is called temporary difference, and it is important to understand that a deferred tax asset is identified when the difference between the expected loss value of the asset is offset by expected future profits. Hence, a deferred tax asset will help reduce a company’s future tax liability. Examples of deferred tax assets are prepaid rent or refundable insurance premiums.

Since 2018, companies can carry forward a deferred tax asset indefinitely. Tax rates exert an effect on the deferred tax asset. If tax rates decrease, the value of the tax asset declines, which means that the company will not be able to use the benefit. On the other hand, an increase in tax rate is beneficial to the company, as the asset value goes up.

Example of a Deferred Tax Asset

Deferred Tax Asset - Sample Tables

The tax rate for the year is 30%, and the company’s estimated that the warranty will be 2% of the revenue. So, the company’s taxable income for the year will be $4,000 – $80 = $3,920. However, most tax agencies will not allow a company to be taxed on deducted warranty expenses; thus, the company will be taxed on the revenue.

As mentioned, the tax rate is 30% and the difference of $24 ($80 * 0.30) between taxes payable in the income statement and the actual tax paid to the tax authorities is the deferred tax asset.

Deferred Tax Assets in Today’s Accounting

In modern accounting, it is important to recognize a deferred tax asset based on timing difference or temporary difference. Hence, over time, a deferred tax asset will reduce as the temporary difference or timing difference will reverse.

Under International Financial Reporting Standards (IFRS), a deferred tax asset/liability is accounted for under IAS12. Furthermore, other accounting standards that deal with deferred taxes include The Institute of Charted Accountant of India, Canadian GAAP, CICA Section 3465, the UK GAAP, Mexican GAAP, and Russian PBU.

Derecognition of Deferred Tax Assets

It is important for management to make good estimates and judgments when it comes to deferred tax assets. There needs to be a prospect that the tax difference will be realized in the future. For example, if a carry-forward loss is allowed, a deferred tax asset may be present on the company’s financial statements because of losses in previous years. In such a situation, a deferred tax asset needs to be documented if and only if there will be enough future taxable profits to service the tax loss.

If the company is not profitable enough in the future, the value of the tax asset will be impaired. A write-down will occur when there is a change in the carrying value of the tax assets, a fundamental error, or a restatement of financial results from previous years. When the write-down occurs, it impacts the income statement for the financial year in which the write-down took place.

More Resources

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