Deferred Tax Liability or Asset (2024)

Created by temporary differences between book accounting and tax accounting rules

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Written byJeff Schmidt

How is a Deferred Tax Liability or Asset Created?

A deferred tax liability (DTL) or deferred tax asset (DTA) is created when there are temporary differences between book (IFRS, GAAP) tax and actual income tax. There are numerous types of transactions that can create temporary differences between pre-tax book income and taxable income, thus creating deferred tax assets or liabilities. While tax, in itself, is a complicated matter to analyze, deferred tax assets and liabilities add another layer of complexity in tax accounting.

To understand what is driving these deferred taxes, it is helpful for an analyst to examine the tax footnotes provided by the company. Often, a company will outline what major transactions during the period have made changes to the balances of deferred tax assets and liabilities. Companies will also reconcile effective tax rates in these footnotes.

Understanding changes in deferred tax assets and deferred tax liabilities allows for improved forecasting of cash flows.

Key Highlights

Temporary differences between book (GAAP/IFRS) accounting rules and tax accounting rules give rise to deferred tax assets (DTAs) and deferred tax liabilities (DTLs).
A temporary difference occurs when there is a temporary timing difference regarding the recognition of revenues and expenses between book accounting and tax accounting.
A common example that causes a DTL is the use of accelerated depreciation for tax purposes and straight-line depreciation for financial reporting. A DTA may be caused when a company recognizes warranty expense for financial reporting but is not allowed to deduct this expense when preparing its tax filings. Loss carryforwards are also deferred tax assets.

Information to Look for in Tax Footnotes

Below are just some major classes of information to look for in footnotes. Understanding this information should allow an analyst to make sense of the changes in deferred tax balances. These transactions are sometimes apparent in the income statement or balance sheet.

Deferred tax liability example: Depreciation

The most notable creation of a deferred tax liability is due to differences between how depreciation is calculated by an appropriate tax authority vs GAAP or IFRS accounting.

Tax authority: Many tax authorities allow and/or require accelerated depreciation on newly acquired property, plant and equipment.

GAAP/IFRS: Unlike tax authorities, GAAP/IFRS rules give accountants freedom to select from multiple methods of depreciation. However, accountants typically use straight-line depreciation when preparing financial statements.

Accelerated depreciation allows for a higher depreciation expense early in an asset’s useful life, thus lowering the company’s taxable income and cash taxes. However, straight-line depreciation expense will be lower relative to accelerated depreciation and will show the company being more profitable, relative to its tax statements. Thus, a deferred tax liability is created with the recognition that this is a temporary difference and the company will end up paying more in taxes in the future.

Deferred tax asset example: Warranty expense

The tax rate for the year is 30%, and the company estimates warranty expense will be 2% of its revenue. Therefore, the company will report taxable income of $3,920 ($4,000 – $80 = $3,920) on its financial statements. However, many tax authorities will not allow a tax deduction for warranty expense; thus, the company will be taxed on the full amount of revenue (in this simple example).

Assuming the tax rate is 30%, the difference in taxes payable for book and tax purposes is $24 ($80 * 30%). Since this is considered a temporary timing difference between book and tax accounting (assuming the company correctly estimated its future warranty expense), the company would create a DTA of $24 to reflect the fact that its actual tax burden going forward will be lower since it effectively “prepaid” taxes.

Derecognition of Deferred Tax Assets

Due to the accounting principle of conservatism, it is important for management to make good estimates and judgments when it comes to deferred tax assets. In other words, there needs to be a prospect that the deferred tax asset will be utilized in the future. For example, if a carryforward loss is allowed, a deferred tax asset will be present on the company’s financial statements (due to losses in previous years). In such a situation, a deferred tax asset needs to be documented if and only if there will be enough future taxable profits to service the tax loss.

If the company is not profitable enough in the future, the value of the deferred tax asset will be impaired. Therefore, the company will create a contra asset account known as a valuation allowance. The valuation allowance reduces the value of the deferred tax asset if the company estimates it will not be able to utilize its DTAs. An increase in the valuation allowance results in an increase in a company’s tax expense on its financial statements.

Analyzing the Effects of a Deferred Tax Handling

After understanding the changes and causes of the deferred tax balance, it is important to also analyze and forecast the effect this will have on future operations. For example, deferred tax assets and liabilities can have a strong impact on cash flow. An increase in deferred tax liabilities or a decrease in deferred tax assets is a source of cash. Likewise, a decrease in the DTL or an increase in the DTA is a use of cash.

Analyzing the change in deferred tax balances should also help to understand the future trend these balances are moving towards. Will the balances continue growing, or is there a high likelihood of a reversal in the near future?

These trends are often indicative of the type of business undertaken by the company. For example, a growing deferred tax liability could signal that a company is capital-intensive. This is because the purchase of new capital assets often comes with accelerated tax depreciation that is larger than the decelerating depreciation of older assets.

Additional Resources

Tax-Free Reorganization
Section 368
Material Participation Tests
Deferred Acquisition Costs (DAC)
See all accounting resources

FAQs

Deferred Tax Liability or Asset? ›

What Is a Deferred Tax Asset vs. a Deferred Tax Liability? A deferred tax asset represents a financial benefit, while a deferred tax liability indicates a future tax obligation or payment due. For instance, retirement savers with traditional 401(k) plans make contributions to their accounts using pre-tax income.

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How to record deferred tax assets and liabilities? ›

A deferred tax asset would be recorded in acquisition accounting because the liability, when settled, will result in a future tax deduction. That is, a deferred tax asset is recognized at the acquisition date since there is a basis difference between book and tax related to the liability.

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What is an example of a deferred asset? ›

Examples of expenditures that are routinely treated as deferred assets are prepaid insurance, prepaid rent, prepaid advertising, and bond issuance costs.

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How to forecast deferred tax assets? ›

Here are some of the most common methods used for forecasting deferred tax assets:

Historical Basis - This method uses past tax returns to predict future tax liabilities. ...
Income Forecasting - This method uses the company's income statement to forecast future tax liabilities and deferred tax assets.

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Mar 6, 2024

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Why does an asset write up create a DTL? ›

If the company will pay more in cash taxes than book taxes in the FUTURE, as a result of these write-ups, or any other changes, then a DTL gets created.

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What is a deferred tax liability on a balance sheet? ›

A deferred tax liability represents an obligation to pay taxes in the future. The obligation originates when a company or individual delays an event that would cause it to also recognize tax expenses in the current period.

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What is journal entry for deferred tax assets? ›

Deferred Tax Asset Journal Entry: A formal record of transaction for a DTA, including the date, the accounts affected, the amounts to be debited and credited, and a brief description. The amount of Deferred Tax Asset to be recorded is calculated using the tax rate and the temporary difference.

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What is the difference between a deferred tax asset and a deferred tax liability? ›

A deferred tax asset is a business tax credit for future taxes, and a deferred tax liability means the business has a tax debt that will need to be paid in the future. You can think of it as paying part of your taxes in advance (deferred tax asset) or paying additional taxes at a future date (deferred tax liability).

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What is a deferred tax asset in simple words? ›

Deferred tax assets are items that may be used for tax relief purposes in the future. Usually, it means that your business has overpaid tax or has paid tax in advance, so it can expect to recoup that money later. This sometimes happens because of changes in tax rules that occur in the middle of the tax year.

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Do deferred tax assets go on the balance sheet? ›

As discussed in ASC 740-10-45-4, a reporting entity should present deferred tax assets and liabilities separate from income taxes payable or receivable on the balance sheet.

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What is the double entry for a deferred tax asset? ›

What is the double entry for a deferred tax asset? In double-entry accounting, generally, the DTA is recognised on the balance sheet as a debit to the DTA account and the corresponding credit would generally be booked to the income tax expense account.

How to treat deferred tax liability in cash flow? ›

Analyzing the Effects of a Deferred Tax Handling

For example, deferred tax assets and liabilities can have a strong impact on cash flow. An increase in deferred tax liabilities or a decrease in deferred tax assets is a source of cash. Likewise, a decrease in the DTL or an increase in the DTA is a use of cash.