Finance Essentials: Deferred Tax Assets and Liabilities Made Simple

Accounting profit is reported on the income statement in accordance to accounting standards; taxable income is the portion of the income that is subject to income taxes under the tax laws of a jurisdiction. A company’s taxable income is the basis of income tax payables or recoveries. A company’s tax expense or benefit appears on the income statement and is an aggregate of tax payables or recoveries from any deferred tax assets or liabilities. 

Deferred Tax Assets appear on the balance sheet when excess amount is paid for income taxes and the company expects to recover the difference during future operations. A valuation allowance is a reserve created against deferred tax assets and is based on the likelihood of realizing the deferred tax assets in future accounting periods. Tax base of an asset is the amount that will be deductible for tax purposes in future periods as the economic benefits become realized, recovering the carrying amount of the asset.

Deferred Tax Asset Example: Deferred (unearned) revenue results from receiving cash now and recognizing the revenue upon the completion of service. Therefore, for tax purposes the cash increases taxable income but accounting income is not updated by not recognizing the revenue. Therefore, paying taxes now creates the deferred tax asset, which would offset later after recognizing the revenue (as taxes have already been paid).

Deferred Tax Liabilities appear on the balance sheet when a deficit amount is paid for income taxes and the company expects to eliminate the deficit during future operations. Tax base of liability is the carrying amount of the liability less any amounts that will be deductible for tax purposes. Tax base of a liability is the carrying amount minus revenue that will not be taxable in the future.

Deferred Tax Liabilities Example: In some instances, tax accelerated depreciation may be larger than accounting, which reduces current taxable income, deferring tax payments for the future. When tax depreciation reduces to zero, the offset of the deferred tax liability would occur upon making larger tax payments and accounting depreciation going to zero.  

Income tax paid is the actual cash flow amount paid for income taxes; the tax base of an asset or liability is the amount valued for tax purposes. Differences between tax bases minus the carrying amount, can be “carried” through future period. For instance, tax loss carry forward (i.e. NOLs) occurs when a company experiences a loss in the current period that may help reduce future taxable income). When income tax rates change, then deferred tax assets and deferred tax liabilities are adjusted and positively correlated. 

Temporary and Permanent Differences between Taxable and Accounting Profit
Permanent differences are differences between tax and financial reporting of revenue (expenses) that will not be reversed (could be due to income or expense items not allowed by tax legislation or tax credit that directly reduces taxes). Note that Reported Effective Tax Rate = Income Tax Expense / Pretax Income of Accounting Profit. 

Taxable temporary differences are when differences result in a taxable amount in a future period of taxable profit vs. when the balance sheet amount is being recovered or settled (Results in DTL with the conditions listed below). The following are scenarios of temporary differences below: 

1. If Asset:  Carrying Amount > Tax Base = Deferred Tax Liability
2. If Asset: Carrying Amount < Tax Base = Deferred Tax Asset
3. If Liability:  Carrying Amount > Tax Base = Deferred Tax Asset
4. If Liability: Carrying Amount < Tax Base = Deferred Tax Liability

Deferred taxes should not be recognized when initial recognition of an asset or liability of a business purchase has no impact on either accounting or taxable profit. Fair value of assets and liabilities acquired in a business purchase is determined on the acquisition date and may differ from previous carrying amounts. Temporary differences will affect deferred taxes as well as the amount of goodwill recognized. Investments in subsidiaries, branches, associates, and interest in joint ventures may lead to temporary differences. The related deferred tax liabilities will be recognized unless (i) the parent is in a position to control the time of the future reversal and (ii) it is probable that the temporary difference will not reverse in the future. Related deferred tax assets will only be recognized if (i) the temporary difference will be reversed in the future and (ii) sufficient taxable profits exist against which the temporary difference can be used. 

Although deferred tax assets and deferred tax liabilities are related to temporary difference, neither is discounted to present value. Both must be adjusted to current tax rates. Deferred tax assets must be assessed at each balance sheet date. If doubt of recovering the deferral exists, then the carrying amount should be reduced to a recoverable amount (reduction can be reversed if recovery is expected to be made, such as Valuation Allowances).  Recognition of deferred taxes directly impact equity.