What Causes a Deferred Tax Asset

Temporary differences between financial accounting and tax reporting can cause a deferred tax asset. This happens when expenses are recorded earlier for tax purposes than for financial reporting purposes, or when revenues are recognized later for tax purposes than for financial reporting purposes. As a result, a temporary difference arises between the book value and the tax basis of the asset or liability, creating a deferred tax asset. This asset represents the future tax savings that will be realized when the temporary difference reverses.

Temporary Differences in Accounting and Taxable Income

A deferred tax asset arises when there are temporary differences between accounting income and taxable income. Temporary differences refer to transactions or events that are recognized differently for accounting purposes than they are for tax purposes, leading to a mismatch in the timing of income and expense recognition.

The following are common types of temporary differences that can result in deferred tax assets:

• Depreciation: For accounting purposes, depreciation is typically spread over the asset’s useful life, whereas tax depreciation may follow a different schedule, leading to differences in the timing of expense recognition.
• Warranty expenses: In accounting, warranty expenses are recognized when the warranty is provided, while for tax purposes, they are only deductible when incurred.
• Installment sales: Under accounting rules, revenue from installment sales is recognized proportionally as cash is received, but for tax purposes, it may be recognized fully in the year of sale.

When temporary differences result in accounting income being higher than taxable income, it creates a deferred tax asset. This is because the company has paid taxes on a larger amount of income than it has recognized for accounting purposes. The deferred tax asset represents the future tax savings that will be realized when the temporary differences reverse in subsequent periods.

To illustrate, consider the following example:

In Year 1, accounting income exceeds taxable income by $20,000, resulting in a deferred tax asset. This asset represents the $2,000 in future tax savings ($20,000 x 10% tax rate). In Year 2, the deferred tax asset will be reversed and recognized as taxable income.

Carryforwards of Net Operating Losses

A deferred tax asset (DTA) is a temporary timing difference between financial reporting and tax reporting that results in a reduction of future taxable income. One common cause of a DTA is carrying forward net operating losses (NOLs).

• NOLs are losses that exceed income in a given tax year.
• Under tax accounting rules, NOLs can be carried back two years or forward up to 20 years to offset future taxable income.
• When an NOL is carried forward, it creates a DTA because the loss has not yet been recognized for tax purposes but has been recognized for financial reporting.

The future reduction in taxable income resulting from the NOL carryforward means that the company will have to pay less in taxes in the future. This reduction in future tax liability corresponds to a DTA on the balance sheet under the deferred tax accounting rules.

Deduction of Expenses in Later Periods

When expenses are recognized for financial reporting purposes in a different period than they are deducted for tax purposes, a deferred tax asset may arise. This occurs when expenses are recognized on the income statement before they are deductible on the tax return.

Here’s an example: Assume that a company incurs an expense of \$10,000 in December 2022. However, this expense is not deductible on the company’s tax return until 2023. As a result, the company will recognize a deferred tax asset of \$10,000 at the end of 2022.

The following table summarizes the impact of deducting expenses in later periods on the financial statements:

Recognition of Revenue in Earlier Periods

A deferred tax asset arises when the timing of recognizing revenue for financial reporting purposes differs from the timing of recognizing revenue for tax purposes. Specifically, if revenue is recognized earlier for financial reporting purposes than for tax purposes, a deferred tax asset is created.

This can occur in various situations, including:

• Installment Sales: Revenue from installment sales is recognized over the period in which the goods or services are delivered for financial reporting purposes, while for tax purposes, revenue is recognized only when cash is received.
• Long-Term Contracts: Revenue from long-term contracts may be recognized using the percentage-of-completion method for financial reporting purposes, but only when the contract is completed for tax purposes.
• Depreciation Differences: Depreciation expense may be accelerated for financial reporting purposes compared to tax purposes, resulting in higher pretax income in earlier periods for financial reporting purposes.

The following table illustrates the impact of recognizing revenue in earlier periods on deferred taxes:

Hey, thanks for sticking with me through this little journey into the world of deferred tax assets. I hope you found it as enlightening as I did. Now, I know taxes and accounting jargon can be a bit of a snoozefest, but trust me, it’s worth understanding these things, especially if you want to get your finances in order. If you’ve got any more questions or just want to chat about money stuff, feel free to swing by again. I’m always down for a good ol’ finance chinwag. Until then, stay cool and keep your taxes in check!