Deferred Tax Asset
A credit that a company receives on its future taxes owed due to paying too much in a current or past tax period
What Is A Deferred Tax Asset (DTA)?
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 exceeds 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, it is good to know how deferred tax assets can impact a business’s cash flows and where to find them in a company’s financial statements.
Key Takeaways
- A deferred tax asset (DTA) represents future tax credits owed to a company due to overpayment in current or past tax periods, arising from disparities between reported income and taxable income.
- DTAs may arise from various factors, such as differences in accounting methods (GAAP vs. tax basis), timing disparities in income recognition, early tax payments, bad debt provisions, and net operating losses (NOLs).
- Fluctuations in tax rates can impact the value of DTAs, with higher rates increasing their value and lower rates decreasing it, influencing future cash flows and tax savings for the company.
- The calculation of DTAs involves assessing the difference between taxes paid and taxes payable based on recorded liabilities, often arising from scenarios like unredeemed gift cards, demonstrating their impact on tax liabilities and future financial performance.
Examples of Deferred Tax Assets
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 several of them to be returned. Therefore, management will estimate the percentage of the products sold that they expect to be sent back.
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% 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 likely to be reduced to $776,000 because the $24,000 warranty expense would likely be deductible when incurred.
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
There are many reasons deferred tax assets may be created:
- GAAP vs. Tax Basis Accounting: Differences between GAAP and tax regulations can lead to variations in reporting revenue or expenses, creating a gap between taxable income and book value, thus allowing for deferred tax assets (DTAs). For instance, companies may anticipate product returns under GAAP, which is permissible, unlike tax-based accounting, where such allowances aren't recognized.
- Timing: Timing disparities in income reporting to the government and financial statement reporting can result in the creation of DTAs. For example, filing taxes before making tax-deductible interest payments can allow businesses to generate DTAs for future deductions.
- Paying Early: Companies may create deferred tax assets when they pay taxes earlier than required. This situation arises when a company remits taxes before utilizing all available tax deductions or credits, resulting in potential tax benefits in subsequent periods.
- Bad Debt: Deferred tax assets can be generated due to the recognition of bad debt expenses for financial reporting purposes. While GAAP permits the allowance for doubtful accounts, tax regulations may necessitate stricter criteria for recognizing such deductions, leading to timing differences and the creation of deferred tax assets.
- Net Loss: Companies experiencing net operating losses (NOLs) may create deferred tax assets by carrying forward these losses to offset future taxable income. NOLs occur when a company's allowable tax deductions exceed its taxable income, resulting in a negative taxable income. These losses can be carried forward to offset future taxable income, thereby generating deferred tax assets.
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 cannot 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.
Businesses often 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.
How 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.
How To Calculate A Deferred Tax Asset
Let's consider a retail company that offers gift cards to its customers. Based on historical data, the company estimates that a certain percentage of gift cards issued will remain unredeemed.
For instance, if the company issues $10,000 worth of gift cards and, historically, 5% go unredeemed, it records a liability of $500 for potential future redemptions.
However, the company cannot deduct this $500 liability for tax purposes until the gift cards are redeemed or expire. Therefore, when the company calculates its taxable income, it doesn't deduct the $500 from its revenue.
Assuming a tax rate of 25%, this means the company will pay taxes on the full $10,000 revenue, resulting in a tax liability of $2,500. However, based on the actual liability recorded in its books, the company should only have paid $2,375 in taxes ($500 x 25%).
Therefore, the difference of $125 ($2,500 - $2,375) between the taxes paid and the taxes payable on the income statement represents a deferred tax asset for the company.
Tax Assets vs. Tax Liabilities
Let's understand the difference between the two in the table below:
| Aspect | Tax Assets | Tax Liabilities |
|---|---|---|
| Nature | Positive for the company | Negative for the company |
| Cause | Occurs when the company overpays taxes and can defer the credit later | Arises when the company pays less in taxes than owed, leading to future payments |
| Common Reasons | Discrepancy between taxable income on books and tax filings | Discrepancy between book and tax income |
| Future Impact | Positively affects future cash flows | Positively affects future cash flows |
Tax Rates on Deferred Tax Assets
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 potentially impacting current tax rates.
Researched and authored by Ethan Sweeney | LinkedIn
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