What Are Deferred Tax Assets and Liabilities?
Deferred tax assets and liabilities arise when there's a temporary difference between how an item is treated for accounting (book) purposes and how it's treated for tax purposes. These differences reverse over time, so companies record deferred tax balances to reflect future tax effects.
A deferred tax liability arises when taxable income will be higher than accounting income in the future (tax paid later); a deferred tax asset arises when taxable income will be lower than accounting income in the future (tax saved later). Both equal the temporary difference multiplied by the applicable tax rate.
- •Future taxable income will be lower than book income
- •Arises from deductible temporary differences (e.g., warranty reserves)
- •Represents future tax savings
- •Recognized only if realization is probable
- •Future taxable income will be higher than book income
- •Arises from taxable temporary differences (e.g., accelerated tax depreciation)
- •Represents future tax owed
- •Always recognized when the difference arises
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Step-by-step worked examples
A company reports $500,000 of accelerated tax depreciation versus book depreciation, creating a $500,000 taxable temporary difference. The tax rate is 25%. Find the deferred tax liability.
Deferred tax liability = $500,000 × 25% = $125,000
A company accrues a $200,000 warranty expense for book purposes that isn't tax-deductible until warranty claims are actually paid, creating a $200,000 deductible temporary difference. Tax rate is 30%. Find the deferred tax asset.
Deferred tax asset = $200,000 × 30% = $60,000
A company has $50,000 of tax-loss carryforwards it expects to fully use against future taxable income. The enacted future tax rate is 21%. Find the deferred tax asset.
Deferred tax asset = $50,000 × 21% = $10,500
Flashcards
Quick quiz
Q1.A $400,000 taxable temporary difference exists with a 20% tax rate. What is the deferred tax liability?
Q2.A deferred tax asset arises when:
Q3.A valuation allowance is used to:
Q4.Accelerated tax depreciation compared to straight-line book depreciation typically creates a:
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Common mistakes
Treating all book-tax differences as deferred tax items. — Correct: Only temporary differences create deferred taxes; permanent differences (like tax-exempt income) never reverse and don't.
Using the current tax rate when a rate change is already enacted for future years. — Correct: Use the enacted future tax rate expected when the difference reverses.
Recognizing a deferred tax asset without considering realizability. — Correct: Assess whether it's more likely than not the asset will be realized; if not, apply a valuation allowance.
Mixing up which difference creates an asset vs a liability. — Correct: Deductible differences → deferred tax asset; taxable differences → deferred tax liability.
FAQ
What are deferred tax assets and liabilities?
They are balance-sheet items reflecting the future tax effects of temporary differences between accounting income and taxable income.
What is the deferred tax formula?
Deferred Tax = Temporary Difference × Tax Rate, using the enacted rate expected when the difference reverses.
What are examples of deferred tax assets and liabilities?
Warranty accruals and tax-loss carryforwards typically create deferred tax assets; accelerated tax depreciation typically creates a deferred tax liability.
How do you calculate a deferred tax asset or liability?
Multiply the temporary difference between the book and tax basis of an asset or liability by the applicable future tax rate.