A deferred tax asset is an item on a companys balance sheet that reduces its taxable income in the future. It is a financial asset that can be redeemed in the future to offset tax liability. Deferred tax assets arise when there are differences between tax rules and accounting rules, or when there is a carryover of tax losses. They can also be created when the tax authorities recognize revenue or expenses at different times than those periods that the company follows, per an accounting standard. For example, if a company accrues an accounting expense in relation to a provision such as bad debts, but tax relief may not be obtained until the provision is utilized, a deferred tax asset can be created.
Deferred tax assets are the opposite of deferred tax liabilities, which represent income taxes owed. A deferred tax liability is created when there are temporary differences between pre-tax book income and taxable income, thus creating deferred tax assets or liabilities. Accelerated depreciation, for example, 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.
It is important to note that deferred tax assets are recognized only when the difference between the loss-value or depreciation of the asset is expected to offset its future profit. 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.
