What are deferred tax assets
A deferred tax asset (DTA) is a balance sheet account, which indicates future savings on tax due to the business. The DTA results when the tax paid exceeds the taxable income as per the accounting income, or when expenses incurred are deductible after recognition in the books of accounts.
Deferred tax assets can also come from net operating loss (NOL) carryforwards and tax credit carryforwards that can be used to reduce future tax liabilities.
Why deferred tax assets occur
The core reason deferred tax assets exist is a timing mismatch. Financial accounting, governed by standards like US GAAP or IFRS, recognizes income and expenses on one timeline. Tax law operates on a different one. When these 2 timelines diverge, temporary differences arise, and those differences create either a deferred tax asset or a deferred tax liability.
The point is that tax law and accounting standards often measure income differently, and the resulting differences between taxable income and accounting income give rise to deferred taxes.
Expenses recognized before tax deductions
This is the most common source of deferred tax assets. Your financial statements record an expense today, but tax law won't let you deduct it until a later period.
Common examples include:
- Warranty reserves: You make provision for an expense of USD 50,000 as warranty expense. This is taken into account immediately under GAAP. For tax purposes, however, the amount will be deductible from income tax payable only upon actual payment for warranty claims, which could happen during subsequent periods.
- Bad debt allowance: The amount of provision is made by the accountant to account for bad debts arising. Generally, there is a restriction imposed by tax laws that this amount will only become deductible when written off.
- Accrued expenses: Accrued expenses, such as salaries payable, create a deferred tax asset when they are recognized in the books before tax rules allow a deduction. The deduction is available only upon payment, resulting in future tax savings.
In each case, you've recognized the expense before you get the tax deduction. That creates a deferred tax asset representing the future tax savings.
Income taxed before accounting recognition
Sometimes the timing mismatch runs the other way. You receive cash and pay tax on it before your financial statements recognize it as revenue.
The clearest example is deferred revenue. If a customer pays USD 120,000 upfront for a 12-month software subscription, some tax jurisdictions require you to recognize that as taxable income immediately. But under accrual accounting, you recognize the revenue monthly over the subscription period. You've paid tax on income your books haven't fully recognized yet, creating a deferred tax asset for the portion that hasn't been recognized.
Net operating loss carryforwards
382 In some cases, an entity may have net operating losses (NOLs) that can be carried forward and used to offset taxable income in future periods.
Under U.S. tax law, NOLs arising after 2017 and carried forward to tax years after 2020 are generally subject to an 80% taxable income limitation, while unused losses may be carried forward indefinitely.
Deferred tax asset vs deferred tax liability
The simplest way to remember the difference: a deferred tax asset means you'll pay less tax in the future. A deferred tax liability means you'll pay more.
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DTA and DTL are sometimes grouped together under the broader term "deferred taxes." When a company has both, they may be netted against each other on the balance sheet if they relate to the same tax authority and meet the applicable accounting requirements. However, netting rules depend on the applicable accounting framework, tax jurisdiction, and reporting entity.
How to calculate deferred tax assets
The formula is: Deferred tax asset = deductible temporary difference × enacted tax rate
1. Deductible temporary difference:
The gap between the carrying value of an asset or liability in your financial statements and its tax base. When this difference will result in a tax deduction in a future period, it's a deductible temporary difference.
2. Enacted tax rate:
The tax rate that has been legally enacted for the future period when the temporary difference is expected to reverse. You use the enacted rate, not an estimated or expected future rate, because accounting standards require it.
3. Future taxable income:
For recording the deferred tax asset, there should be a reasonable possibility of recognizing future taxable income from which such benefit can be realized. Otherwise, it may be necessary to provide a valuation allowance.
Deferred tax asset calculation example
The company recognizes USD $50,000 of warranty expenses in the current accounting period; however, the tax rules only permit the deduction of the expenses when the claim is paid, in the following accounting period. The tax rate of the company is enacted at 25%.
Deferred tax asset = USD $50,000 × 25% = USD $12,500
Common deferred tax asset examples
Generally, deferred tax assets are created when companies record an expense in the books or recognize a tax benefit in their accounts. In other words, a deferred tax asset represents tax benefits that a company creates through time differences or loss or credit carryforwards.
1. Warranty expense
For instance, a manufacturer offers customers products with a warranty of 2 years. The company makes an estimated cost of warranty amounting to USD $80,000, which it records as an expense. The tax rules only recognize the deductions for tax purposes when the claims are paid; hence, until the claims are paid, the deductible temporary difference will be USD $80,000, generating DTA of USD $20,000 at 25% tax rate.
2. Bad debt allowance
The company assumes 3% of its accounts receivable, i.e., USD $30,000, will be uncollectible and provides an allowance account. As a result, it decreases accounting profits presently. In tax accounting, however, the provision can only be deducted after writing off the specific amount involved. As a result, USD 30,000 leads to temporary difference and DTA. At a 25% tax rate, the USD $30,000 deductible temporary difference creates a DTA of USD $7,500.
3. Net operating losses
As explained above, companies that generate NOLs can carry those forward to offset future taxable income. This is especially relevant for early-stage companies or businesses going through a difficult period. The DTA created by an NOL carryforward represents the tax savings available when profitability returns.
4. Accrued expenses
A company accrues USD $40,000 in employee bonuses at Dec 31 but doesn't pay them until March of the following year. The expense is in this year's income statement. The tax deduction comes in the following year when payment is made. That timing difference creates a DTA.
5. Deferred revenue
A SaaS firm earns USD $120,000 upfront from customers for providing annual service on July 1. Under tax regulations, all amounts received are currently taxable even though recognized over a period of one year in the income statement. Thus, the firm pays taxes on USD $60,000 of revenue before it is recognized for accounting purposes. This USD $60,000 temporary difference results in a deferred tax asset.
6. Tax credits
Unused tax credits, such as research and development credits, can also create deferred tax assets if the company can't use them in the current period but expects to use them in a future period. The credit represents a direct reduction of future tax liability rather than a deduction against taxable income, making the accounting treatment slightly different from temporary differences. Confirm the treatment with your accountant.
How deferred tax assets appear on the balance sheet
Deferred tax assets appear on the balance sheet as assets because they represent a genuine future economic benefit: lower taxes owed.
Is a deferred tax asset a current asset?
In accordance with ASC 740 of US GAAP, all deferred tax assets and liabilities should be reported under the category of non-current in the balance sheet irrespective of their timing of reversal. You cannot expect deferred tax assets being classified under the heading of current and non-current. All deferred tax assets will come under the category of non-current.
Under IFRS (IAS 12), deferred tax assets are also classified as non-current.
If you're a founder reviewing your balance sheet and see deferred tax assets listed under non-current assets, that's standard. If your accountant has structured it differently, confirm the applicable accounting standard and jurisdiction.
What is a deferred tax asset valuation allowance?
Valuation allowance is a contra-asset account used in order to decrease the carrying amount of a deferred tax asset when there is uncertainty regarding the future generation of sufficient profit.
Under US GAAP, the standard is "more likely than not," meaning a greater than 50% probability. If you can't meet that threshold for the full DTA, you record a valuation allowance for the portion that's uncertain.
How deferred tax assets reverse
A deferred tax asset reverses when the future tax benefit is actually used. The mechanics are straightforward: as the temporary difference that created the DTA unwinds, the asset decreases.
Going back to the warranty example: the company booked USD 50,000 in warranty expense and recorded a USD 12,500 DTA. In the following year, USD 30,000 in warranty claims are paid and become tax-deductible.
The reversal looks like this:
- Portion of temporary difference used: USD 30,000
- DTA reversal: USD 30,000 × 25% = USD 7,500
- Remaining DTA: USD 12,500 – USD 7,500 = USD 5,000
The tax benefit of USD 7,500 is recognized in the income statement in the year the claims are paid, reducing tax expense for that period. The remaining USD 5,000 DTA sits on the balance sheet until the remaining USD 20,000 in claims is settled.
Why deferred tax assets matter for founders and finance teams
Deferred tax assets aren't just an accounting technicality. They have real practical implications:
Balance sheet impact:
A DTA adds to your total assets. For businesses seeking financing or investment, a large DTA with a substantial valuation allowance can raise questions about future profitability expectations.
Tax planning:
Understanding your DTAs helps you anticipate when tax benefits will flow through and how they'll affect your effective tax rate in future periods. A company with significant NOL carryforwards, for example, may have lower cash tax payments for several years after returning to profitability.
Explaining book vs tax differences:
If your taxable income is significantly different from your accounting profit, deferred taxes explain much of the gap. For founders reviewing financial statements, DTAs are a key part of understanding why those 2 numbers diverge.
Cash flow visibility:
While a DTA isn't cash, its reversal reduces future cash tax payments. That has real cash flow implications in years when temporary differences unwind.
Forecasting requirements:
Recognizing or maintaining a DTA requires realistic income projections. Finance teams need to revisit DTA balances whenever business conditions change materially.
How Aspire helps you build your financial infrastructure
Aspire's1 business accounts allows businesses to establish a solid financial footing. Businesses are able to track transactions, receive and send payments, as well as store money and transfer funds among multiple currencies accepted by Aspire.
With the combination of corporate cards and payment management, you have an all-in-one solution for your daily financial activities and record keeping.
Frequently asked questions
Can deferred tax assets expire?
Yes. Some deferred tax assets, such as certain tax credits and net operating loss carryforwards in specific jurisdictions, may expire if they are not used within the allowed period. Companies must assess whether they can realize the benefit before expiration.
Can a deferred tax asset become worthless?
Yes. In the case where a company doesn’t have sufficient taxable income in the future, the company’s deferred tax assets cannot be used, which may lead to a reduction in its asset by a valuation allowance.
Are deferred tax assets considered cash?
No. Deferred tax assets cannot be regarded as either cash or cash equivalent as they indicate future reductions in tax payment that may lead to improved cash flow in the future.
Why do startups often have large deferred tax assets?
The reason why startups possess significant deferred tax assets is because of the likelihood of them experiencing operating losses during the growth phase of their operations.
Can deferred tax assets increase company valuation?
Although deferred tax assets cannot directly influence company valuation, they indirectly do as they increase after-tax cash flows for the company.
What happens to deferred tax assets during an acquisition?
Deferred tax assets are reviewed as part of the acquisition process. Their value may change depending on the buyer's ability to utilize the tax benefits and the applicable tax rules governing ownership changes.
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