Deferred Tax Asset

A deferred tax asset (DTA) is a credit that a company receives on its future taxes owed due to paying too much in a current or past tax period.

DTA occurs when a company's taxable income on its reported income conflicts with the taxable income on its books. When their reported taxable income is greater than the book value, the company may be able to create a DTA. 

Also, it means that in the future, the company will be able to carry over the extra expense they made and receive a deduction on future taxes. 

As we will explore below, this may happen for several reasons. First, knowing how deferred tax assets can impact a business's cash flows and where to find them in a company's financial statements is good.

example:

• A common reason that deferred tax assets are created is due to warranties.
• When a company sells a product with a warranty, for example, grills, they expect a number of them to be sent back. Therefore, management will estimate the percentage of the products sold that they expect to be sent back.
• In this case, imagine the company sold $1,000,000 of grills at an 80% profit margin for a pretax income of $800,000. Furthermore, imagine the company expects 3% of them to be returned under warranty. This case would decrease the company's pretax income by $24,000.
• The company will write this off on its income statement, and its taxable income will only be $776,000. On their taxes, however, their taxable income is still $800,000 because the grills still need to be returned. 
• When the grills are eventually returned, the company can create a DTA and deduct the expense from their taxable income anytime in the future.

Reasons behind Deferred Tax Asset

Many reasons deferred tax assets may be created:

• Timing
• GAAP vs. tax basis accounting
• Paying early
• Bad debt
• Net loss

Below we go through these common reasons in greater detail.

1. GAAP vs. Tax Basis Accounting

Often the rules stipulated in the generally accepted accounting principles (GAAP) that govern how companies report their finances in their public financial statements can differ from the rules that the government uses to determine taxes owed.

This situation can stem from differences in reporting revenue or expenses. For example, in some cases, revenue may be collected during one period but reported in another. This can happen for different reasons, such as fiscal and tax year differences.

This can create a discrepancy between taxable income and book value, allowing a business to create a DTA.

An example of this would be warranted. When a company issues warrants, they usually estimate that several products will be sent back. 

This is allowed under GAAP but not under tax basis accounting, meaning that the company will have to report all its income as taxable income, even for the products it believes it will have to refund.

2. Timing 

Another common reason for this stems from a difference in the time a company reports its income to the government when they report its financial statements. This discrepancy may create an opportunity for businesses to create a DTA.

For example, a company might file its taxes before making a tax-deductible interest payment. 

In other cases, businesses may pay more than they owe on their taxes. This case, of course, may be carried over for a deduction on their future taxes.

How to Find Deferred Tax Assets?

A company may also be able to create a credit on their future taxes if they determine that they will not be able to collect a debt owed to them. This becomes a loss that can be used as a credit on future taxes.

Lastly, if a company incurs a net loss during a period, it can carry over as a deduction from future taxes.

This type of asset is considered an intangible asset. It is not a physical asset but is still listed on the balance sheet because it represents an asset to the company. This asset can decrease a company's taxes in the future, increasing its available cash.

To find out the cause of the intangible assets, an investor can find the information listed in the tax footnotes that a company provides in its financial statements.

Often businesses will provide additional information in the footnotes underneath their balance sheet or income statement. For example, deferred tax assets are widespread, and companies will provide information about them here.

The way that companies receive deferred tax assets can be essential for understanding the future cash flows the business will have. As a result, this way can have an impact on future earnings and can change financial models.

Tax Assets vs. Tax Liabilities

Deferred tax assets are positive for a company. It happens when a company pays more taxes than it owes and can defer the credit later.

It often arises when a company has a discrepancy between their taxable income on their books and taxable income in their tax filings.

Deferred tax liabilities, however, have the opposite effect, although they arise for the same reasons. This effect occurs when a company pays less than they owe on its taxes and will be forced to pay more later to make it up.

Deferred tax liabilities are often created for similar reasons that deferred tax assets are created. Often they arise due to a discrepancy in their book and tax filings.

Instead of the company paying more taxes than they had to, they end up paying too little and will owe the government in the future.

In summary, deferred tax liabilities negatively impact a company's future cash flows, while deferred tax assets positively affect future cash flows.

Tax Rates Effect

The tax rate and, specifically, the changing tax rates can impact the value DTAs have for a company. This impact can have both positive and negative effects on a company.

When the tax rate rises, the value of a DTA increases. This action is beneficial for companies as it can provide them with more significant credit that can be applied when filing taxes in the future. As a result, the company can save more money when this occurs.

Likewise, when the tax rate decreases, the value of a DTA also decreases. However, again, this hurts companies because it reduces the amount of money a company can save on their taxes in the future.

Companies can hold DTAs indefinitely, so they may choose to hold them if they believe the tax rate is likely to rise. 

On the other hand, if the tax rate is expected to decrease, it is in a company's best interest to use its tax credits as soon as possible, for if they do not, it will lose value.

This information can inform businesses near elections and other political events that have the potential to impact current tax rates.

Researched and authored by Ethan Sweeney | LinkedIn

Free Resources

To continue learning and advancing your career, check out these additional helpful WSO resources:

• Balance Sheet
• Cash Conversion Cycle
• Cost of Goods Manufactured (COGM)
• Operating Cash Flow
• Retained Earnings