When trying to grasp deferred tax assets and liabilities, it’s crucial to remember the distinction between financial and tax reporting. These two types of accounting use distinct rules and methods, which might result in both deferred tax assets and liabilities.
Financial reporting requires the use of accounting principles, such as those established by the Financial Accounting Standards Board (FASB). Financial statements show pre-tax net income, income tax expenses, and net income after taxes.
Tax reporting, on the other hand, requires tax authorities to establish rules and regulations governing the preparation and filing of tax returns. Tax authorities include the Internal Revenue Service and local state governments.
In this post, we’ll go over all you need to know about deferred tax assets and liabilities, so you have a better idea of what they signify and why they’re significant.
Deferred tax asset vs. liability
Deferred tax assets and liabilities are diametrically opposed. A deferred tax asset is a business tax credit, loss carryover, or other tax characteristic that reduces future taxes, whereas a deferred tax liability indicates that the firm owes taxes that must be paid later.
You might think of it as paying some of your taxes ahead of time (deferred tax asset) or paying more taxes later (deferred tax liability).
Is deferred tax an asset or a liability?
It depends. There are two sorts of deferred tax items: asset and liability. One reflects money owed by the business (deferred tax liability), while the other indicates money owed to the business (deferred tax asset).
What is a deferred tax asset?
A deferred tax asset (DTA) is a balance-sheet entry that shows the difference between the company’s internal accounting and the taxes owing. For example, if your firm paid its taxes in full and then obtained a tax deduction for that time, the unused deduction can be applied to future tax files as a deferred tax asset.
In 2017, Congress approved the Tax Cuts and Jobs Act, which slashed corporate tax rates from 35% to a maximum of 21%. If a firm had paid its taxes in advance, it would have overpaid by 14%. The gap between tax payments and liabilities results in a deferred tax asset.
- What kind of asset is a deferred tax asset? A deferred tax asset is classified as an intangible asset since it is not a physical thing such as equipment or a building. It only appears on the balance sheet.
- Is a deferred tax asset considered a financial asset? Yes, a DTA is a financial asset since it reflects a tax overpayment that may be repaid in the future.
- Where do deferred tax assets appear on the balance sheet? On the balance sheet, they are classified as “non-current assets.”
- When does a deferred tax asset need to be used? Deferred tax assets never expire and can be used when it is most convenient for the firm.
- Remember: Deferred tax assets can always be carried forward to future tax files, but they cannot be used to previous tax filings.
What causes a deferred tax asset?
A deferred tax asset occurs when the income on the tax return differs from the income in the company’s accounting records.
How do deferred tax assets work?
As an example, suppose you hired a ridesharing service, but the car had a flat tire and you had to walk home in the rain. The firm compensated you by crediting your app account with $50. If you had intended to spend $50 on ridesharing the next month, you can now budget for $0 since the credit you have will cancel it out.
The app credit in this case indicates your deferred tax asset. You haven’t utilized it yet, but you know it has future worth, so you can plan how to spend accordingly.
Examples of deferred tax assets
Net operating loss: The company had a financial loss during that time.
Tax overpayment: You paid too much in taxes during the previous period.
Business costs: When expenses are recorded in one accounting system but not in another.
Revenue: Amounts collected during one accounting period but recognized in another.
Bad debt: An unpaid debt is reported as income before being written off as uncollectible. When the unpaid receivable is ultimately recognized, the bad debt becomes a deferred tax asset.
What is a deferred tax liability?
A deferred tax liability (DTL) is a tax payment that is reported on a company’s balance sheet but is not due until a future tax filing. A payroll tax holiday is a sort of deferred tax liability that allows businesses to postpone paying payroll taxes for a later date. The tax break provides a financial gain to the corporation today but becomes a liability in the future.
Certain tax incentives will result in a deferred tax liability journal entry, providing the company with temporary tax relief that will be recovered later. Depreciation charges, such as the yearly devaluation of a fleet of business cars, can result in deferred tax liabilities.
- Is deferred tax liability a debt? A deferred tax liability journal entry reflects a tax payment that, due to scheduling discrepancies in accounting operations, can be delayed until a later date.
- Where do deferred tax liabilities appear on the balance sheet? On the balance sheet, they are classified as “non-current liabilities.”
- Deferred tax liabilities: good or bad? Depending on your circumstances, deferred tax liability might be neutral or beneficial. It suggests you owe money but do not have to pay it immediately. The disadvantage is that your company must have money put aside to pay off this debt in the future.
What causes a deferred tax liability?
Any temporary discrepancy between the amount of money owing in taxes and the amount of money that must be paid in the current accounting cycle results in a deferred tax liability.
How do deferred tax liabilities work?
Imagine yourself in a bar with an open tab to better understand the notion of deferred tax liability. You walk to the bar at the end of the night to settle your tab, but the bartender has accidentally closed the register and cannot process your payment. You agree to return to the bar and clear your tab on your next visit. You make a note of the outstanding sum and maintain enough cash on hand to pay it off.
The gap in time between you owing a debt and the bartender realizing that it will not be paid until a later date is analogous to a deferred tax liability. A company has a tax balance that must be paid, but not immediately.
Deferred tax liability examples
Depreciation of assets: The IRS employs an advanced asset depreciation model, resulting in a discrepancy between the company’s balance sheet value and its tax value. This is the most typical type of deferred tax liability.
Tax underpayment: The business did not pay enough tax in the previous cycle and will need to make up the difference in the future cycle.
Installment sale: When a product is purchased in installments, the business reports the entire value of the sale on their balance sheet but only pays taxes on each yearly installment. The corporation acknowledges that it has a deferred tax liability for future payments on the transaction.
Evaluating deferred tax assets and liabilities
It might be difficult to predict when and if you will be able to take advantage of a deferred tax asset. The balance is not hidden because it appears in the financial statements. Analysts can account for deferred tax amounts, resulting in a more accurate financial picture.
Example in context
Net operating loss carryforwards are an important kind of deferred tax. These arise when your company incurs a net loss but is unable to deduct all of it in the current year. The remainder of the loss is carried forward until you have a sufficient net income to report the loss on your tax return.
But, of course, you cannot anticipate the future. You don’t know which years you’ll be able to utilize the carryforwards in, or if you’ll be able to use them all before the tax code prohibits you from carrying the loss forward into future years.
Tax expense calculation
When analyzing deferrals, you should always consider the following equation:
Income tax expense = taxes payable + deferred tax liability – deferred tax asset
Understanding this equation will allow you to better comprehend your income statement.
Questions to ask your CPA:
If you have deferred tax assets and liabilities, lenders, investors, or possible buyers are likely to inquire about them. Before you speak with key stakeholders regarding financial problems, ask your CPA the following questions:
- What is the breakdown of the netted sum on the balance sheet in terms of deferred tax assets and liabilities?
- What makes up the assets and liabilities? What occurrences created them?
- When do you anticipate the company realizing its tax assets and liabilities?
- How likely do you think it is that the company will be able to realize its tax assets and liabilities? Is it unavoidable, highly likely, or simply somewhat likely?
Additional Considerations
The sales and costs you declare on your income statement may not necessarily convert into taxable income and deductions. Tax accounting and financial accounting follow somewhat different standards, which is why your company’s taxable income does not necessarily correspond to the net income on your financial accounts.
Temporary versus permanent tax differences
Some of these cases result in permanent tax discrepancies. For example, municipal bond interest income may be removed from taxable income on tax returns but included in accounting (book) income.
Other variations are only transient. These variances are due to time. You will ultimately recognize your income and spending, although you may do so sooner under one method than another.
Temporary timing discrepancies result in deferred tax assets and liabilities. Deferred tax assets imply that you have accrued future deductions, or positive cash flow, whereas deferred tax liabilities indicate a future tax liability.
Difference in depreciation methods
Variations in depreciation methods for book and taxable income result in temporary discrepancies. The IRS may permit a company to employ an accelerated form of depreciation, which results in higher tax expenditure in the early years of an asset’s life and less expense later on.
The distinction between depreciation expenses in accounting records and on tax returns is short-term. Throughout the asset’s life, the total amount depreciated remains constant. The variations are related to the timing of the expenditures each year.
Consider the following example of deferred tax assets. Assume a firm loses money when it sells an asset. If the business can claim the loss on a future tax return, it is considered a deferred tax asset.
Corporations’ deferred tax obligations are netted against deferred tax assets and reflected on the balance sheet. For pass-through organizations such as S corporations, partnerships, and sole proprietorships, the net is reported on a supporting schedule of your company tax return.
Accelerated asset depreciation
To incentivize capital investment, the IRS utilizes an enhanced depreciation model that enables businesses to evaluate larger asset depreciation sooner, resulting in an increased tax deduction straight away. The disparity in depreciation models leads in a delayed tax liability.
That’s because, while you take a larger deduction at first, the difference in depreciation schedules adjusts over time, and in later years, the firm basically “pays back” the original tax deductions until the difference between depreciation models equals out.
How it works
Consider the famous Bed Bath & Beyond coupons as an example of this principle. Imagine that instead of sending you a 20% off coupon each month, Bed Bath & Beyond sends you a 50% off coupon, then a 40% off coupon, then a 30% off coupon, and so on until they offer you a coupon that raises prices by 30%.
Overall, you’ll have earned an average of 20% off for each coupon, but they provided you a considerably higher discount up front, which you gradually paid back over time.
To prepare for the month when you’ll spend 30% more for your Bed Bath & Beyond purchases, you should set aside additional money. In a word, the deferred tax liability for accelerated depreciation schedules is as follows: you receive a significant discount at the outset, which is steadily decreased over time until you owe money.
Accelerated asset depreciation example
A 401(k) is a typical type of tax-deferred liability for people. A 401(k) is a tax-deferred retirement plan. You don’t pay taxes on 401(k) contributions until years or decades later, when you withdraw them. A firm predicts these sorts of future expenditures and has a cash reserve to cover them.
Come to us for Help
After reviewing the definitions and examples of deferred tax assets and liabilities, you may have a better understanding of our balance sheet’s future tax credits and debits. To avoid tax filing errors related to these topics, feel free to contact us at PSA CPA and we will do the heavy lifting for you.
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