Deferred Tax AssetsWhat does it mean to have deferred tax assets?

Financial accounting follows the rules set forth by the Financial Accounting Standards Board (FASB).

On the other hand, tax accounting follows the rules set forth by the IRS and local state governments.

With how financial accounting and tax accounting follow different standards, there will come a time when the two would show different net income figures.

The taxable income might be higher or lower than the net income figure that appears on a business’s income statement.

When this happens, the computation of income taxes between the two would show different figures.

This results in the creation of a deferred tax situation, which further leads to deferred tax assets or liabilities appearing on the business’s balance sheet.

If the taxable income figure is lower than the net income figure on the income statement, it creates a deferred tax liability.

This means that the business is bound to pay more income taxes in the future.

On the other hand, if the taxable income figure is higher than the net income figure on the income statement, it creates a deferred tax asset.

If a business has a deferred tax asset, it may pay less income taxes in the future.

In this article, we will be covering deferred tax assets along with what situations lead to the creation of deferred taxes and what does it mean for the business to have deferred tax assets?

What is a Deferred Tax Asset?

A deferred tax asset is an asset account that appears on a business balance sheet if there is a difference in the taxable income and net income figures.

It can also appear on the balance sheet when a business overpays its taxes.

What it does is that it reduces the amount of income taxes that the business has to pay in the future.

One can think of it as paying a part of your future income taxes in advance.

For example, if a business has a deferred tax asset of $120, it will eventually pay $120 less income taxes sometime in the future.

Since a deferred tax asset doesn’t have a physical form to represent it, it is an intangible asset.

As for whether it’s a current or non-current asset, it’s a non-current asset.

This is because, as of 2018, a business can indefinitely carry forward its deferred tax assets.

This means that a deferred tax asset doesn’t expire, meaning that it has an indefinite life.

Do note that while a business can always carry forward its deferred tax assets to future tax filings, it cannot apply them to past tax filings.

In 2017, the US corporate income tax rate was reduced to a maximum of 21% (from 35%).

This led to the creation of a deferred tax situation for businesses that have paid the year’s taxes in advance.

Particularly, there is a difference of 14%.

This means that businesses that paid in advance overpaid their taxes by 14%.

This overpayment is a deferred tax asset on the part of these businesses.

What Situations Lead to the Creation of Deferred Tax Assets?

When there is a difference in the taxable income that appears on the tax return and the net income that appears on a business’s income statement, it will result in the creation of deferred tax assets.

When the business incurs a net operating loss in the current taxable period

A  business incurs a net operating loss if it has more expenses than revenue. In tax accounting, net operating loss occurs when the tax deductions exceed the business’s taxable income.

As a form of tax relief, the IRS allows businesses to carry over their net operating losses in the succeeding years.

This means that the business won’t have to pay income taxes for the current taxable period as it technically has zero taxable income.

And on top of that, the business may use the net operating losses to reduce the taxable income in future periods, which ultimately reduces future tax payments.

Do note that as of 2018, a business can only apply net operating loss carryforwards up to 80% of the subsequent year’s taxable income.

For example, let’s say that in year 1, a business incurs a net operating loss of $360,000.

In year 2, it was able to bounce back and earn a net operating income of $420,000.

The business can then use the net operating loss from year 1 to reduce the taxable income for year 2.

However, it can only claim up to $336,000 of net operating carryforward, which is 80% of the current year’s operating income ($420,000 x 80% = $336,000).

The business can still claim the remaining $24,0000 net operating loss in year 3 and beyond.

When there’s a timing difference in the recognition of revenue and/or expenses

There may be timing differences in the recognition of revenue and/or expenses between financial accounting and tax accounting.

A prominent example of this is the recognition of bad debts expense.

In financial accounting, a business is allowed to accrue bad debts expense even if there is no actual write-off.

Every period, a business needs to set an amount as an allowance for uncollectible accounts.

On the other hand, tax accounting only allows the recognition of bad debts expense when there is an actual write-off of accounts receivables.

This means that unless the business deems the receivable to be 100% uncollectible, it cannot claim any deduction (due to bad debts) from it.

This creates a situation where an expense was already recognized in the financial statements, but not yet on the tax returns.

Meaning that the business is technically paying more income taxes than it should have. As such, it needs to record a deferred tax asset.

When the business overpays its taxes

The overpayment of taxes creates a deferred tax asset.

It could be the result of a miscalculation of taxable income, where it is higher than it should be.

Or it could be that recent changes in the tax rate results in overpayment (usually when the tax rate is lowered).

Both situations lead to the creation of a deferred tax asset.

The business can then use the deferred tax asset to reduce the tax liability of a future taxable period.

Calculation of Deferred Tax Asset

Before we calculate any deferred tax asset, let’s remember first that it only arises if the taxable income is higher than the net income that appears on the business’s financial statements.

So if the taxable income is equal to or lesser than the net income on the income statement, there will be no deferred tax assets.

Now with that out the way, the calculation for deferred tax assets is pretty simple.

We only need to apply the tax rate to the difference between the taxable income and net income figures.

For example, let’s say that the business reported a net income of $5,000 in the current year.

It should also be noted that it recognized a $500 bad debts expense to set the allowance for uncollectible accounts.

There were no actual write-offs of receivables during the year.

This means that for tax accounting, the $500 bad debts expense is not yet a valid deduction.

As such, the business taxable income is $5,500, resulting in a difference of $500.

This difference creates a deferred tax asset on the part of the business.

Assuming the business tax rate is 21%, the $500 difference creates a $105 deferred tax asset