What are deferred tax assets?
When and how do deferred tax assets occur, and how do you account for deferred tax assets?
All of this and more is covered in this short video.
With a term like deferred tax assets, the first logical step to take is to look at the
meaning of each of the words.
Tax indicates that we are dealing with the topic of taxation.
Deferred means that something has been postponed, and assets means that we own it, we have ownership.
Keep that in mind when we explore deferred tax assets in more depth.
Before we discuss deferred tax assets, let's make sure that we have the same basic understanding
of how taxation journal entries are recorded under normal circumstances,
when a company is profitable.
A company with revenue of $1 million, and costs of $900,000,
has an Earnings Before Taxes of $100,000.
At a 35% tax rate, the income tax expense will be $35,000, and the Net Income $65,000.
The journal entry for recording the income tax expense is debit income tax expense in
the income statement, and credit income tax payable on the balance sheet.
When the tax payable is subsequently transferred to the tax authorities,
you debit income tax payable and credit cash.
So far, so good.
But what if you are a start-up company that does not generate profit yet?
StartUp Inc has not generated any revenue in its first year, but it did incur costs,
and therefore has a negative Earnings Before Tax of $100,000.
The income tax expense on that Earnings Before Taxes is negative $35,000,
and Net Income negative $65,000.
The CEO of StartUp Inc sends a message to the IRS to ask for a cash refund of the $35,000,
which the tax officer finds very amusing.
He responds that as StartUp Inc has not paid any tax in the past, he cannot provide a refund.
However, what he can do is provide a "rain check": giving StartUp Inc the right to come
back on another day to receive what they could not get today.
The technical term for the raincheck is "Net Operating Loss Carry-Forward", and that is
where the deferred tax asset comes in!
The way the negative income tax expense gets booked is: credit income tax expense in the
income statement, debit Deferred Tax Assets on the balance sheet.
Deferred tax assets reduce taxes paid in future periods.
StartUp Inc goes into its second year of operation, and carries over that Deferred Tax Asset on
the balance sheet into the new year.
StartUp Inc now generates $1 million of revenue, and $100,000 Earnings Before Tax.
On this Earnings Before Tax, we record an income tax charge of $35,000.
In terms of journal entries, we now debit income tax expense in the income statement,
and rather than crediting income tax payable on the balance sheet, we can credit and deplete
the deferred tax asset.
StartUp Inc has offset its year 1 loss against year 2 profits.
Which type of items create deferred tax assets?
Annual reports of companies listed on the stock market provide good insights on that.
The common denominators are that there are temporary (timing) differences between "tax"
and "book" (or GAAP) accounting, and that a deferred tax asset occurs when taxable income
is higher than "book" income.
Some of the items that companies mention as creators of deferred tax assets are pension,
employee benefits plans, non-deductible reserves, accruals, and many more.
The next question to answer is: what is a Deferred Tax Asset impairment?
Such a decrease of the balance sheet asset occurs when there is a tax rate change, or
when the likelihood of being able to recover deferred tax assets against future sources
of taxable income changes.
Let's take a tax rate change as an example.
We go back to StartUp Inc.
The Net Operating Loss Carry-Forward amount was $100,000, which at a 35% tax rate created
a deferred tax asset of $35,000.
If the tax rate gets reduced from 35% to 21%, that $100,000 of Net Operating Loss Carry-Forward
now needs to be used at the new tax rate to offset future profits.
The deferred tax asset is therefore now only worth $21,000, and a $14,000 non-cash impairment
charge gets taken on the deferred tax asset.
That wraps up our deferred tax assets discussion.
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