Deferred Tax Asset: What It Is, And How To Calculate And Use It
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Summary:
A deferred tax asset is a crucial financial concept for businesses, helping them reduce future tax liability. This article explains what a deferred tax asset is, how it’s calculated, provides real-world examples, and highlights its importance in financial statements.
A deferred tax asset is an item on a company’s balance sheet that reduces its taxable income in the future. When a business overpays taxes, this excess amount becomes an asset, eventually returned to the company as tax relief. Unlike a deferred tax liability, which suggests increased future tax obligations, a deferred tax asset offers tax advantages.
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Understanding deferred tax assets
Deferred tax assets emerge when taxes paid or carried forward can’t yet be recognized on the income statement. These assets are formed due to differences between tax authority rules and accounting standards. This often results in temporary disparities between the amount of tax reported on the company’s income statement and the actual amount of tax paid to tax authorities.
Deferred tax assets serve a significant role in reducing a company’s upcoming tax liability. They act as a financial cushion by offsetting future tax payments through the recognition of past overpayments or timing differences.
Recognition of a deferred tax asset occurs when there’s a likelihood that the asset’s future benefits, such as the depreciation or loss-value of an asset, will offset its potential future profits. This anticipation of offsetting future profits with the asset’s benefits is a critical factor in determining when to recognize a deferred tax asset.
Examples of deferred tax assets
A classic example of a deferred tax asset is the carryover of losses to lower taxable income in subsequent years. When a business faces a loss in a financial year, it’s typically allowed to apply that loss to reduce its taxable income in future periods. This loss becomes an asset because it can be used to decrease future tax obligations.
Another scenario arises from differences between accounting rules and tax rules. For instance, deferred tax assets come into play when expenses are recognized in a company’s income statement before they’re mandated to be recognized by tax authorities. Similarly, differences in recognizing revenue for tax purposes and financial reporting can also create opportunities for deferred tax assets.
In essence, deferred tax assets are formed whenever there’s a discrepancy between tax bases and rules for assets and liabilities. They provide a way for businesses to align their financial statements with their tax obligations, contributing to overall financial transparency.
How to calculate a deferred tax asset
Calculating a deferred tax asset involves scenarios where taxes payable on the income statement differ from actual taxes paid to tax authorities. For instance, let’s consider a computer manufacturing company. Based on past experience, it estimates that 2% of the total production will be sent back for warranty repairs in the next year. If the company’s total revenue is $3,000 and the warranty expense in its books is $60 (2% x $3,000), then the company’s taxable income is $2,940.
However, tax authorities might not allow companies to deduct expenses based on expected warranties. In this case, the company is required to pay taxes on the full $3,000. If the 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.
Why do deferred tax assets occur?
Deferred tax assets occur due to several factors:
- Prepaid taxes: A balance sheet may reflect a deferred tax asset if a company has prepaid its taxes.
- Timing differences: Timing disparities between when a company pays its taxes and when the tax authority credits it can also lead to deferred tax assets.
- Overpaid taxes: Deferred tax assets can also arise when a company has overpaid its taxes in previous periods.
These scenarios result in deferred tax assets being recorded on the balance sheet to accurately represent the company’s financial position.
Do deferred tax assets carry forward?
Starting in 2018, deferred tax assets can be carried forward indefinitely, never expiring. This flexibility provides companies with a valuable tool for optimizing their tax strategies. By carrying forward deferred tax assets, businesses can strategically apply them whenever it aligns with their financial goals and objectives. This approach contributes to effective tax planning, allowing companies to make the most of available tax benefits and minimize future tax obligations.
What is a deferred tax asset vs. a deferred tax liability?
A deferred tax asset and a deferred tax liability are distinct concepts with financial implications for companies. A deferred tax asset represents a potential advantage, offering companies the possibility of tax relief in the future. This type of asset arises from overpaid taxes or timing differences between when tax payments are recognized in financial statements and when they’re due to tax authorities.
On the other hand, a deferred tax liability signals future tax obligations. It reflects situations where a company’s financial practices result in anticipated tax payments. For example, contributions to traditional 401(k) plans using pre-tax income create a deferred tax liability. When individuals withdraw money from these accounts, they owe income tax on those contributions.
In summary, while a deferred tax asset contributes positively to a company’s financial outlook by potentially reducing tax liabilities, a deferred tax liability represents an impending tax obligation.
Frequently asked questions
What are the benefits of deferred tax assets?
Deferred tax assets offer enhanced tax planning capabilities, allowing companies to strategically use them to optimize tax benefits.
Are there any drawbacks to deferred tax assets?
Yes, there are cons associated with deferred tax assets, such as being subject to changes in tax laws and requiring careful tracking and documentation.
How long can deferred tax assets be carried forward?
Deferred tax assets can be carried forward indefinitely starting from 2018, providing companies with long-term flexibility in their tax planning strategies.
Do deferred tax assets impact financial reporting?
Yes, deferred tax assets can impact a company’s financial reporting by affecting its tax provision and future tax liabilities.
Are deferred tax assets affected by changes in profitability?
Yes, the utilization of deferred tax assets is dependent on a company’s future profitability, as they can only be applied against future taxable income.
Key takeaways
- Deferred tax assets offer enhanced tax planning capabilities.
- Carrying forward deferred tax assets provides flexibility for future tax planning.
- Changes in tax laws can impact the effectiveness of deferred tax assets.
- Deferred tax assets require careful tracking and documentation.
- Utilization of deferred tax assets depends on future profitability.
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