What are Deferred Tax Assets and Deferred Tax Liabilities? How They Impact Your Business Finances

Have you ever wondered why your company’s tax bill doesn’t always match your financial statements? Or why sometimes your business seems to owe taxes even when profits are down? The answer might lie in Deferred Tax Accounting.

Deferred tax is an accounting concept that represents the ‘difference’ between the profit reported on financial statements and the taxable profit. This difference arises because income and expenses may be recorded differently in your financial statements compared to how they are treated for tax purposes.

Deferred tax accounting is essential for accurate financial reporting. It reflects the current and future tax effects on a company’s income, ensuring net earnings are properly reported within the same period.

These differences are categorized as:

• Temporary Differences: The difference between the book income and tax income that can reverse over time. Temporary differences fundamentally represent the timing variations when transactions are recognized in IFRS or US GAAP financial statements and for tax purposes. They can either be taxable or deductible.
• Permanent Differences: These are differences that do not reverse over time, such as fines or penalties. These are items that are included in accounting profit but never in taxable profit, or vice versa.

The temporary differences can lead to the creation of either a deferred tax asset (DTA) or a deferred tax liability (DTL), depending on whether they result in future tax savings or future tax expenses.

Let’s see what is a deferred tax asset is and what is a deferred tax liability and how they differ from each other.

Deferred Tax Asset vs Liability: Understanding the Difference

Deferred Tax Assets (DTA) and Deferred Tax Liabilities (DTL) are essential to a company’s financial statements.

A Deferred Tax Asset arises when a business has paid more tax than required on its book profit. In such cases, the company can claim the excess tax in the future, thus creating an asset on its balance sheet.

A deferred tax asset can arise in various situations, such as when a business incurs a net loss and carries it forward to offset against future profits. This effectively reduces the company’s taxable income in the following year, leading to a lower tax liability. It’s important to note that since the net loss was incurred in a specific year, any future tax benefits resulting from it should be recorded in that same year, thereby recognizing it as a deferred tax asset.

Deferred Tax Asset Example: If an entity’s book profit includes bad debts that are not yet allowed for tax purposes, the entity pays more tax now and thus creates a DTA. When this provision is allowed in future years, the business will pay less tax.

Deferred Tax Liability, on the other hand, occurs when a business pays less tax at present but expects to pay more in the future. For example – when a company’s tax statement reflects higher depreciation than its income statement, it results in lower tax liability for that year. However, since this difference is temporary, the company will eventually need to pay the taxes owed in future years, and this obligation is recorded as a deferred tax liability.

Let’s understand DTA and DTL with an example:

Assume that your business has purchased machinery worth $100,000. For tax purposes, you choose to depreciate the equipment over 3 years, but for accounting purposes, you depreciate it over 5 years. This creates a temporary difference.

In the first few years, you record higher depreciation for tax purposes, which will reduce your taxable income. However, this creates a deferred income tax liability because the accounting income is higher than the taxable income. The DTL represents the taxes you’ll eventually have to pay when your taxable income catches up.

However, if your business incurs a loss in one year, you may carry the loss forward and offset profits in future years. This creates a DTA because it will reduce future taxable income, giving you a tax benefit down the road.

When Is a Deferred Tax Recorded?

Deferred tax assets and liabilities can arise from various financial events. Some common scenarios include:

• Difference in Depreciation Methods: A deferred tax can be created if a company uses different depreciation methods for its book accounting and for tax purposes.
• Variation in Depreciation Rates: Discrepancies between the depreciation rate used by a company and the rate prescribed by tax authorities can also lead to deferred tax.
• Net Operating Losses: A deferred tax asset is generated when a company incurs a loss during a particular year. This loss can be carried forward to offset profits in future years, thus lowering the tax liability. The deferred tax asset (DTA) is recorded in the year the loss occurs.
• Unrealized Revenues and Expenses: Tax laws do not impose tax on unrealized revenues. For instance, if a company has unrealized receivables from debtors, it will be recorded in the income statement under accounting laws, but not for taxation. This difference creates a deferred tax liability since the company will need to pay tax once these receivables are realized.

Conversely, expenses recorded in the books but not yet incurred are not included in tax calculations. This means that if the company’s book profit is lower than the profit shown in the tax statement, it will lead to advance tax payment and will create a deferred tax asset.

How is Deferred Tax Calculated?

Deferred tax is calculated based on the difference between the gross profit reported in the Profit & Loss Account and the taxable income in the tax statement. Here’s an example to illustrate it:

Consider a company with a 30% tax rate that sells a product worth $10,000, but receives payments from its customer on an instalment basis over the next five years – $2,000 annually. For financial accounting purposes, the company recognizes the entire $10,000 revenue at the time of the sale, while it records only $2,000 based on the instalment method for tax purposes. This results in an $8,000 temporary difference that the company expects to liquidate within the next five years. The company records $2,400 in deferred tax liability on its financial statements.

Accounting for Deferred Taxes

• Initial Recognition and Measurement: The initial step involves identifying and quantifying temporary differences as per the date of reporting. This includes identifying the tax bases of assets and liabilities and calculating the applicable tax rates when these differences are expected to reverse.

• Subsequent Measurement: At the end of each reporting period, deferred tax assets and liabilities are re-evaluated. This includes reassessing carrying amounts, tax bases, and the tax rates used. Any changes in tax rates can affect the measurement of deferred tax.

• Balance Sheet Presentation: Deferred tax assets and liabilities appear as non-current items on the balance sheet. They can be offset if they relate to the same tax jurisdiction and legal entity.

• Income Statement Presentation: Deferred tax effects are reported in the income statement and impact the overall tax expense for the period. Accurate presentation requires differentiating between current and deferred tax charges or benefits.

Derecognition of Deferred Tax Assets

Due to the accounting principle of conservatism, businesses must carefully assess their deferred tax assets. In other words, there needs to be virtual certainty about how deferred tax assets will be used in the future. For example, if a carryforward loss is allowed, a deferred tax asset will appear on the company’s financial statements, reflecting past losses. In this case, a deferred tax asset should be recorded only if there is sufficient future taxable earnings to offset the tax loss.

However, if the company is not profitable enough, the deferred tax asset value will be reduced. To account for this, the company needs to create a contra-asset account. Also known as a valuation allowance, it reduces the value of the deferred tax asset if the company cannot fully utilize its DTAs. An increase in the valuation allowance leads to higher tax expenses on the company’s financial statements.

Impact on Business Finances

Deferred Tax Assets improve the cash flow of a business by reducing tax obligations. For example, a company experiencing losses can carry them forward to offset profits in upcoming years, effectively lowering tax liabilities.

Deferred Tax Liabilities, on the other hand, lead to cash flow issues as they represent future tax obligations. It means that you need to reserve some funds to cover these future payments. If not managed properly, DTLs can cause a cash crunch when the liability becomes due.

Why Are Deferred Taxes Important?

Deferred tax asset and liability help in accurately assessing a company’s financial performance. Here are some of the key reasons why they are important:

Accurate Financial Planning

Deferred taxes provide a clearer picture of future tax payments and savings. They help companies plan their cash flow more effectively and keep adequate funds for future tax liabilities.

Evaluate Company’s Financial Position

Deferred taxes ensure that income and expenses are recorded in the period they occur, even if they are taxed at a different time. This matching principle gives a more accurate representation of a company’s financial health and reflects the true profit or loss.

Compliance with Accounting Standards

Deferred tax accounting ensures compliance with accounting standards like US GAAP or IFRS. These standards require companies to disclose deferred taxes and maintain consistency in financial reporting. Without it, financial statements may not provide a true and fair view of company’s financial position.

Improved Decision-Making by Stakeholders

Investors and stakeholders use financial statements to assess a company’s performance and future potential. Deferred income taxes help them understand the timing of tax benefits and obligations for informed decision-making. For instance, a large deferred tax liability might indicate higher future tax expenses, which could impact a company’s valuation.

Master Deferred Tax Accounting with KnowVisory’s Professional Expertise

Deferred tax assets and liabilities are essential for managing your business’s finances, but getting a grip on DTAs and DTLs isn’t always easy.

Partner with KnowVisory’s experts to keep your tax strategy optimized. Our finance and accounting specialists can simplify deferred tax accounting for you, helping you make better financial decisions and avoid tax penalties.

Leverage our finance and accounting services to streamline tax management, improve cash flow, and focus on what matters most—growing your business.