When you’re preparing financial statements for your small business, one of the most important documents is the balance sheet. There is an abundance of information on the balance sheet. Understanding this information will give you a better idea of your company’s financial health.
When looking through your balance sheet, you may find that your accountant noted either deferred tax assets or deferred tax liabilities. These assets and liabilities can directly affect your company’s tax liability for years, so it’s essential to understand what the deferrals represent and how likely you are to realize them.
In this article, we’ll cover everything you need to know about deferred tax assets and liabilities. By the end of the article, you should have a much better understanding of what these terms are and why they’re important.
What are deferred tax assets and liabilities?
Deferred tax assets and liabilities are financial items on a company’s balance sheet. Deferred tax assets and liabilities exist because the income on the tax return is different than income in the accounting records (income per book). Here are some transactions that generate deferred tax asset and liability balances.
- Accounts receivable that are uncollectible
- Options expensing
- Net operating losses
- Depreciable assets
A deferred tax liability means that taxable income will be higher in future years than income reported in the accounting records. Depreciation expenses can generate deferred tax liabilities.
Assume, for example, that a business uses an accelerated depreciation method for taxes, and the straight-line method for accounting purposes.
The tax return will have more depreciation expense in early years, and less in later years. Because the expense is lower in future years, income will be higher, and so will the tax liability.
The straight-line method means that the accounting records will use the same dollar amount of depreciation expense each year.
A deferred tax asset means that the business will have more expenses on the tax return in future years, when compared to the accounting records. More expense not only reduces taxable income, but also future tax liability.
For example, assume that a business can carryforward a capital loss on the sale of an asset into future years for tax reasons, but not in the accounting records.
When the capital loss is recognized on the tax return in a future year, taxable income will be lower, and the tax liability will also be lower.
When trying to understand deferred tax assets and liabilities, differentiating between financial reporting and tax reporting is vital. Financial reporting involves accounting rules, such as those set forth by the Financial Accounting Standards Board (FASB). Financial statements report pre-tax net income, income tax expense and net income after taxes.
Tax reporting, on the other hand, calls for tax authorities to set the rules and regulations regarding the preparation and filing of tax returns. Examples include the IRS and local state governments.
You’ll always want to consider the following equation when evaluating deferrals:
Income tax expense = taxes payable + deferred tax liability – deferred tax asset
Understanding this equation can help you better understand your income statement, as we’ll touch on below.
What creates deferred tax assets and deferred tax liabilities?
The revenue and expenses you report on your income statement don’t always translate into income and deductions for tax purposes. Tax accounting and financial accounting have slightly different rules, which is why your business’s taxable income isn’t always the same as the net income on your financial statements.
Some of these instances result in permanent tax differences. For example, interest income from municipal bonds may be excluded from taxable income on the tax return, but included in accounting (book) income.
Other differences are temporary. These differences have to do with timing. You’ll end up recognizing the income and expenses eventually, but you just may realize them sooner under one system than you do under the other.
Differences in depreciation methods for book income and taxable income generate temporary differences.
The IRS may allow a firm to use an accelerated method of depreciation, which generates more tax expense in the early years of an asset’s life, and less expense in later years.
The difference between depreciation expense in the accounting records and the tax return is only temporary. The total amount depreciated for a particular asset is the same over the life of the asset. The differences are due to the timing of the expense each year.
Consider the following example for deferred tax assets. Let’s say that a business incurs a loss on the sale of an asset. If the firm can recognize the loss on a future tax return, the loss is a deferred tax asset.
Temporary timing differences create deferred tax assets and liabilities. Deferred tax assets indicate that you’ve accumulated future deductions — in other words, a positive cash flow — while deferred tax liabilities indicate a future tax liability.
For corporations, deferred tax liabilities are netted against deferred tax assets and reported on the balance sheet. For pass-through entities like S corporations, partnerships and sole proprietorships, the net appears on a supporting schedule on your business tax return.
Evaluating deferred tax assets and liabilities
It can be tricky to determine when, and if, you’ll be able to take advantage of a deferred tax asset. The balance isn’t hidden because it’s reported in the financial statements. Analysts can take deferred tax balances into account, so there’s not “distortion” of the financial picture.
For example, net operating loss carryforwards are a significant type of deferred tax. These occur when your business has a net loss but isn’t able to deduct all of the loss in the current year. The remaining balance of the loss is carried forward until you have a high enough net income to post the loss on a tax return.
But, of course, you can’t predict the future. You don’t know what years you’ll be eligible to use the carryforwards or whether you can use them all before the tax law prevents you from carrying the loss forward into future years.
Understanding your deferred tax assets and liabilities
If you have deferred tax assets and liabilities, there’s a good chance that lenders, investors, or potential buyers will want to know about them. Before you meet with essential stakeholders about financial matters, ask your CPA these types of questions:
- Of the netted figure on the balance sheet, what is the breakdown between deferred tax assets and deferred tax liabilities?
- What comprises the assets and liabilities? What events caused them?
- When do you expect the business to realize the tax assets and liabilities?
- How likely do you think it is that the business will be able to recognize the tax assets and liabilities? Is it inevitable, very likely, or only somewhat likely?
The FASB requires disclosure of deferred tax balances in the financial statements, found here.
Examples of deferred assets and liabilities
To better understand the differences between asset and liability deferrals, let’s take a more in-depth look at some cases.
One of the most common instances of deferred assets is with warranties. Take a company, for example, that earns $3 million in revenue and has $1 million in expenses, resulting in a $2 million profit. The company can break down its expenses and find that $250,000 is a future liability for warranty expenses. If merchandise is sold under warranty, the seller must post an estimate of the future liability for warranty expenses.
Tax authorities do not classify future warranties as an expense, mainly because the expenses have yet to occur. The disallowed warranty expense increases taxable income and the firm’s tax liability in the current year. However, the company can recognize $250,000 as a deferred tax asset on its balance sheet.
Now, let’s take a look at deferred tax liabilities and how the accelerated depreciation method comes into play. Consider the following example.
A company with a 21% tax rate depreciates an asset worth $20,000 placed in service in 2018 over 20 years. In the second year of the asset’s service, the company records $1,800 accelerated depreciation in its tax books and $1,000 of straight-line depreciation in its financial books.
The difference of $800 is temporary because both the tax return and the accounting records will recognize the same dollar amount of total depreciation over the life of the asset. The company records $168 ($800 × 21%) as a deferred tax liability.
Tax Cuts and Jobs Act
Recently, Congress passed the Tax Cuts and Jobs Act. This law dramatically overhauled the personal tax system in the United States. However, it also reduced the maximum corporate tax rate from 35% to 21%. This law changed how companies need to treat deferred assets and liabilities both from a current tax and future years perspective.
Many companies had existing deferred assets and liabilities in place when Congress passed the law. Businesses were forced to immediately calculate the future benefits of the existing deferred tax balances at the new (lower) tax rates. The lower corporate tax rates reduced the future value of deferred tax assets and liabilities.
Now that the new tax rules have been in place, there shouldn’t be much more confusion about future deferments. Deferred tax balances should be calculated based on the corporate tax rates stated in the Tax Cuts and Jobs Act.
But, if you’re worried that you may have filed incorrectly, you may want to consult an accounting professional and potentially file an amended tax return. Doing so allows for full disclosure and could reduce the likelihood of a future audit.
Use reliable accounting software, and discuss any deferred tax balances with a tax preparer.
Making sense of deferred tax assets and liabilities
As a new small business owner, deferred tax assets and expenses are one example of a complex subject that could easily confuse business owners, complicating matters in future periods.
If you would like to know more about how deferred assets and liabilities impact your small business, be sure to contact your trusted accountant or tax professional. Doing so will help ensure you follow proper accounting standards while receiving the maximum tax benefit.