Deferred Tax Asset

Deferred tax asset is an asset recognized when taxable income and hence tax paid in current period is higher than the tax amount worked out based on accrual basis or where loss carryforward is available. A deferred tax asset moves a portion of the tax expense to future periods to better match tax expense with accounting income.

Taxable income is the income calculated in accordance with income tax rules to which the statutory tax rate is applied to calculate the income tax payable. This is different from the accounting principles and standards used to determine the accrual-based accounting income. Earnings before income taxes and taxable income differ in two ways: (a) first, certain incomes and expenses are not recognized for tax purposes, and (b) second, income and expense are recognized in different periods due to difference in tax and accounting rules. The first type of differences is called permanent differences and the second type are the temporary differences. Temporary differences are either taxable or deductible. Taxable temporary differences are those which result in a higher taxable income in future period and deductible temporary differences are those which result in a lower taxable income in future. A deferred tax asset represents the deductible temporary differences.

A deferred tax can also arise in event of an operating loss that can be carried forward to future periods for offsetting against future period taxable income.

Example and journal entries

Let’s consider a company that has earnings before income taxes (EBT) of $30 million. During the period, an amount of $4 million was received on a 2-year rental contract in advance half of which is included in the EBT. For tax purpose, the whole $4 million is included in current period income resulting in a taxable income of $32 million. If the statutory tax rate is 40%, income tax payable works out to $12.8 million (=$32 million × 40%). However, on accrual basis, tax ought to be $12 million (=$30 million × 40%). The excess tax paid in current year of $0.8 million must be moved to future periods. The following journal entry must be passed to recognize the deferred tax asset:

Account Dr Cr
Current tax expense ($30 million × 0.4) 12.00
Deferred tax asset 0.80
Income tax payable ($32 million × 0.4) 12.80

The example above was a simplification. Two factors must be considered before recognition a deferred tax asset. First, because the tax benefit is expected to be received in future the valuation of a deferred tax asset must be based on statutory tax rates applicable in future. Second, enough future earnings must be expected in future periods to allow realization of the deferred tax asset.

In the second year, let’s assume that the earnings before income taxes rose to $36 million (including the $2 million rent income). Taxable income in the second year is $34 million because the $2 million rent was recognized in the first year in accordance with tax rules. If the statutory tax rate is 40%, income tax payable amount works out to $13.6 million ($34 million × 40%) while accrual-based income tax expense works out to $14.4 million ($36 million × 40%). You can see that income tax payable is lower by $0.8 million because $2 million income which relates to the second year was taxed in first year. We recognized a deferred tax asset at the end of the first year which can be now used to arrive at the correct income tax expense.

The following journal entry shows the recognition of second year income tax:

Account Dr Cr
Income tax expense ($36 million × 0.4) 14.40
Deferred tax asset 0.80
Income tax payable ($34 million × 0.4) 13.60

Written by Obaidullah Jan, ACA, CFA and last modified on