Deferred tax assets

Deferred tax assets generally arise from accounting expenses that are considered deductible temporary differences - meaning the related tax deduction is delayed and will be realized in a future period. They can also arise when accounting income is lower than the income included under tax rules.

As a summary, deferred tax assets arise when temporary differences cause the accounting net income to be lower than taxable income:

$$\text{Accounting net income}<\text{Taxable income}$$

This can happen because accounting revenues are lower than tax revenues, accounting expenses are higher than tax expenses, or both:

$$\text{Accounting revenues}<\text{Tax revenues}$$

$$\text{Accounting expense}>\text{Tax expense}$$

Examples of temporary differences resulting in deferred tax assets

Examples of situations leading to the recognition of deferred tax assets are as follows:

Expenses recognized in accounting income but not in taxable income

1. Accounting for bad debts can result in deferred tax assets because accounting rules require to use the allowance method that recognizes expenses in the accounting books in advance of the actual write-off. The direct write-off method is used in the tax books where the expenses are only recognized upon actual write-off.
2. Accounting for warranties can result in deferred tax assets similar to bad debts by using the allowance method in the accounting books which recognizes warranty expenses in advance, while in the tax books, the warranty expense is only recognized when claims have been made by the customer and the costs have been paid.
3. Accrued expenses can result in deferred tax assets because the tax books use cash basis. Accordingly, these accrued expenses have been expensed in accounting but only recognized in the tax books when actually paid.

Income recognized in taxable income but not in accounting income

1. Advance rent received by the company results in deferred tax assets because in the accounting books, the rent received is not yet earned and is recorded as a liability account while in the tax books, the rent received is recorded already as an income using the cash basis of accounting.
2. Losses carried forward are net losses that are used to reduce the taxable income for future periods. They create deferred tax assets because they are future deductible amounts.

Accounting for deferred tax assets

Deferred tax assets are computed as follows:

Deductible temporary difference	XX
Multiply: future enacted tax rate	XX%
Deferred tax asset	XX

The deferred tax asset computed above is booked as follows:

Account	Debit	Credit	Financial statement element
Deferred tax asset	XXX		Asset
Deferred tax expense		XXX	Expense
To record deferred tax asset

Same as for deferred tax liabilities, the company then has to follow the source of the deferred tax asset in the subsequent periods to ensure that any reversals of temporary difference are accounted for.

For example when the accrued expenses in the accounting books in Year 1 were finally paid in year 2, any deferred tax assets recorded on it from Year 1 should be reversed in year 2, as follows:

Account	Debit	Credit	Financial statement element
Deferred tax expense	XXX		Expense
Deferred tax asset		XXX	Asset
To record reversal of temporary differences recognized in prior year

Valuation allowance: A deferred tax asset is recognized only to the extent it’s more likely than not to be realized. If it’s more likely than not that some or all of the DTA won’t be realized - for example, because of a history of losses - the company records a valuation allowance that reduces the DTA, debiting income tax expense and crediting the valuation allowance.

GAAP vs. IFRS: Under US GAAP (ASC 740), the DTA is recorded at its full amount and then reduced by a separate valuation allowance account. Under IFRS (IAS 12), there’s no separate valuation allowance - the DTA is simply recognized only up to the amount that’s probable of being realized.

Deferred tax assets example

Achievable Co. has booked estimated credit losses on accounts receivables amounting to:

• $30,000 in Year 1
• $10,000 in Year 2
• $2,000 in Year 3.

In addition, $5,000 bad debts were written-off in Year 2 and $10,000 in Year 3. The tax rate of the company is 20%.

Solution

When companies book estimated credit losses, these are not normally recognized in the tax books because uncollectible accounts are only recognized in the tax books when they are actually written-off. This creates a temporary difference resulting in deferred tax assets because accounting income is lower than taxable income in this situation.

The best way to determine the deferred tax impact of transactions with multiple years of tax impact would be to summarize the differences between the accounting income and tax income for all years affected.

In the table below, the difference row is accounting expense minus tax expense - positive means the deferred tax asset grows that year. The temporary difference row restates the same fact from the income side (how much lower, or in parentheses higher, accounting income is than taxable income), so its sign is the opposite of the difference row above it. The deferred tax impact follows the sign of the difference row: positive builds the DTA, negative (Year 3) reverses it.

	Year 1	Year 2	Year 3
Accounting expense: Estimated credit losses	$30,000	$10,000	$2,000
Tax expense: Actual write-offs	$0	$5,000	$10,000
Difference	$30,000	$5,000	($8,000)
Temporary difference: Accounting income is higher (lower) compared to tax income by:	($30,000)	($5,000)	$8,000
Multiply: Tax rate	20%	20%	20%
Deferred tax impact	$6,000	$1,000	($1,600)

From the above, it is good to remember that write-offs do not impact the estimated credit losses in the income statement. The expense recognized in the taxable income computation are the actual write-offs of uncollectible accounts.

For Year 1, the journal entry will be as follows:

Account	Debit	Credit	Financial statement element
Deferred tax asset	$6,000		Asset
Deferred tax expense		$6,000	Expense
To record deferred tax asset on year 1

The Year 2 entry follows the same pattern: it increases the deferred tax asset by another $1,000 (debit deferred tax asset, credit deferred tax expense).

For Year 3, the journal entry will be a reversal of the previously established deferred tax assets since there are more write-offs than allowance during the year.

Account	Debit	Credit	Financial statement element
Deferred tax expense	$1,600		Expense
Deferred tax asset		$1,600	Asset
To record reversal of deferred tax assets on year 3

The balance of the deferred tax assets in the balance sheet at the end of each year would be as follows:

	Year 1	Year 2	Year 3
Deferred tax assets	$6,000	$7,000	$5,400

We still have deferred tax assets of $5,400 in the balance sheet at the end of Year 3 because the estimated credit losses accrued in Year 1 have not yet been fully written-off as of Year 3.

Questions on the exam could focus on different areas of the computation so it is best for candidates to know how to account for the deferred tax impact of transactions until the end of the transaction.