What are Deferred Tax Assets and Liabilities?

Financial reporting is a very important activity in the realm of business. To be able to make sound decisions on the money coming into a business, accountants and tax specialists put many terms and numbers to use in order to create financial and tax reports each year.

Two of the most important terms in financial statements are deferred tax asset and deferred tax liability. While both these entities are components of a company’s tax regimen, they are polar opposites of each other.

“Deferred tax” basically means that while a tax amount has been established, it either hasn’t been paid or credited yet. When there is a tax credit due to a company somewhere in the future, it is termed deferred tax credit. On the other hand, if there is a tax amount that a company is yet to pay (but it has been kept aside as tax money), it is accounted for as deferred tax liability. You see the difference now – while deferred tax asset is a known credit amount to be realized in the future, the deferred tax liability is a known tax amount set aside to be paid in the future.

Understanding the two deferred tax terms needs a little more insight into the following topics:

Meaning of deferred tax asset, how it works, how it is calculated and an example
Meaning of deferred tax liability, how it works, how it is calculated and an example
Deferred tax asset vs. deferred tax liability

What is Deferred Tax Asset?

A deferred tax asset can be found on the tax balance sheets of a company as an item that is due to be credited as tax returns. A deferred tax asset occurs when a company pays a tax amount that is greater than its tax liabilities. In such a scenario, the government returns the excess amount to the company according to the taxation cycle. This overpaid amount gets recorded in the company’s balance sheets as deferred tax asset. Deferred tax asset can also be created by paying your taxes in advance.

Since this tax amount is recorded and due to be credited to the company in the future, it is referred to as deferred tax asset. They work to bring down the tax liability to the company for the future. Deferred tax assets can be carried over to the consequent financial years, according to IRS.

Inferring more into getting reimbursed for tax payment in the future, it is evident that overpayment can be safely viewed as an asset.

Depending on accounting standards that companies and authorities follow, there can be differences in the timeline for recognizing revenue and expenses. While companies typically follow the established corporate laws to file their taxes, authorities are governed by income tax laws. The timelines on both are different, creating a mismatch in taxation filing and issuing reimbursement. This instance creates an event of a deferred tax asset on the company’s balance sheets.

Some other reasons that create a deferred tax asset in a company are listed below along with examples to help you understand better:

Losses in Business

Say, for example, that your business incurred a loss in the previous financial year. While filing for taxes, taxation and corporate laws allow that this loss be carried forward into subsequent years. By doing this, you would be able to set off the profits of the next year with the losses carried forward, thus reducing your tax liability. Doing this converts the loss into a deferred tax asset.

Calculating Depreciation

There are two methods for calculating depreciation: the straight-line method and the double depreciation method. Depreciating your assets with higher expenses, in the beginning, helps in lowering the tax liabilities. This can be leveraged to create deferred tax assets. In fact, the rate of depreciation applied to assets also differs between financial accounting and tax accounting, which further creates a difference in the tax liability amount, creating deferred tax assets in the process.

Expenses

Sometimes, certain expenses that are recognized in the financial statement of a company aren’t necessarily counted as expenses in the tax accounting procedure. Let’s understand this with the following example:

Consider a company A with the following income and tax statements:

Revenue	$10,000
Expenses	$3,000
Legal	$1,000
Income taxable	$6,000
Tax at the rate of 30%	$1,800

Here, the tax liability to the company is $1,800. On the other hand, the tax statement of the same company will count expenses as follows:

Revenue	$10,000
Expense	$3,000
Legal	$1,000
Income taxable	$7,000
Tax at the rate of 30%	$2,100

Evidently, the tax statement creates an overpay of tax, creating a deferred tax asset worth $2,100 - $1,800 = $300, which will reflect in the balance sheet.

Revenues

Sometimes, there are instances where the revenue of a company gets accounted for in the tax section before it gets into the finance section. This creates a deferred tax asset in the company since the revenue doesn’t get adjusted in financial accounting first.

Warranties

Warranties function differently in the taxation universe and financial statements. While they need to be accounted for in a company’s financial statements, the tax authorities do not recognize them as expenses. Say that company A has a revenue of $10,000 out of which $3,000 are expenses. In these expenses, there is $500 worth of warranties. While the company recognizes this, the tax authorities do not allow the reduction of this amount as expenses, resulting in the creation of a deferred tax asset.

What is Deferred Tax Liability?

Deferred tax liability refers to the item on the balance sheet of a company that reflects how much tax a company owed to the government for the period in question, but isn’t due to be paid as of now. In such a case, when the company has a definite future expense in tax coming up, it sets apart an amount to cover that tax expense and labels is deferred tax liability.

As opposed to deferred tax assets, the deferred tax liability is the underpaid amount that a company has recorded in the filing of its taxes. This is the tax payment that the company is liable to pay in the future. The taxes are applied to the income of the current year, while the tax record for the filing that occurs in the next calendar year must happen now, which gives rise to deferred tax liabilities.

Why Does Deferred Tax Liability Occur?

Deferred tax liabilities usually occur when events that incur taxes are put off, causing an underpayment calculation creating a deferred liability. In short, there is a time-lapse between the instance where tax was accrued and the instance when it is due to be paid; it is this lag that causes deferred tax liability to occur.

Deferred tax liabilities can happen due to three major reasons. Much like deferred tax assets, depreciation calculations cause a difference in the way expenses are recorded in the company ledgers between accounting and taxation. The accounting ledger may not account for certain expenses that taxation counts differently, resulting in an underpayment. In fact, underpayment is the second major reason why deferred tax liabilities are created.

The third reason a deferred tax liability may occur is because of installment sales. When a company sells a product on installment, it records the sale paid in full, while deferring the tax on each installment every year. This creates a deferred tax liability. Say, for example, that company A records a sale of $2,000 worth of appliances. However, the consumer agrees to pay the sum over two years in installments of $1,000 a year. In this scenario, the company records a sale of $2,000 dollars in accounts, while in its taxes, the true installment value is recorded.

Therefore, $1,000 every year for two years, at a tax of 20% would incur a deferred tax liability of $1,000 x 0.2 = $200.

Deferred Taxes are Commonplace - Learn to Leverage Them (Conclusion)

While calculating the tax expense at your company, you may consider the following equation:

Income tax expense = Total tax to be paid + deferred tax liability – deferred tax assets

It is important to keep the deferred tax liabilities and asset numbers in order so that decision-making is easier on the part of lenders, potential buyers or those interested to invest in the company. Many reasons cause taxation and financial accounting to move out of sync; this is why deferred taxes exist – to provide better clarity and visibility into the statements of a company.

Key Takeaways

Deferred taxes are typically the result of the gap between taxation and financial accounting timelines between companies and authorities. While deferred tax assets translate into reducing the taxes payable on the term, the deferred tax liabilities mark deficit tax yet to be paid before the due date
Deferred tax assets and liabilities both represent an amount of money that is owed in two different ways: deferred tax assets are owed to the company, while deferred tax liability is owed to the government
Depreciation is the one common point between deferred tax assets and liabilities that creates discrepancies in tax and accounting calculations. Apart from that, the factors impacting these figures are installment sales, warranties, expenses, revenues, etc.
Deferred tax assets and revenue can be smartly managed to help a company keep balanced account statements and books