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Understanding Deferred Tax Assets

Of all the items on a balance sheet statement, I've found none more frustrating and obscure than the deferred tax items. I know what accounts receivable and property plant and equipment are, but deferred taxes always left me scratching my head. In order to clear up some of this confusion, let's take a closer look at what these items represent.

Drop the zero ...
Deferred taxes exist because accounting for shareholder income (what the company tells you) and taxable income (what the company tells the tax man) are different. Why? Let's say you're on a date with an attractive person of the opposite sex, and this person politely asks you your disposable income. You employ a brilliant accountant who was able to make your income look like it was $0, thus precluding you from paying any taxes. Would you triumphantly declare to your date that you made all of zero dollars in taxable income last year? Companies paint as dreary a picture as they can to the tax man in order to reduce or delay tax payments, but to someone they're trying to impress (shareholders), they'll probably show a rosier picture.

Break it down
Let's start with the good part: deferred tax assets. Let's break this down into easily understandable chunks. Instead of deferred, which is somewhat obscure, think delayed, or future. We know what taxes are, and we know that assets are a good thing. In other words, a deferred tax asset (DTA) is a future tax benefit. We like those. A DTA is created when shareholder income (what the company tells you) is less than taxable income (what Uncle Sam sees). A DTA is kind of like a prepaid tax.

Quick example
What are some events that result in DTAs? Warranties, restructuring charges, net operating losses, and unrealized security losses can create future tax benefits. For example, companies like Circuit City (NYSE: CC  ) and Motley Fool Stock Advisor recommendation Best Buy (NYSE: BBY  ) sell a ton of electronics that come with multi-year warranties. Every year, these companies make estimates on their future warranty expenses based on how many returns they think they'll get. The company tells you, the shareholder, these estimates, and expenses them, thus decreasing shareholder income (and shareholder taxes). However, Uncle Sam says that warranty expenses cannot be recognized until the actual event occurs, and as a result, shareholder income is lower than taxable income. Thus, Best Buy, until the item return actually occurs, has to report higher income (and pay higher taxes) to Uncle Sam then to you. This results in a deferred tax asset, because Best Buy "prepaid" these warranty taxes and will receive a future benefit (lower taxes) when the warranty event actually occurs.

Valuation allowance
A valuation allowance is a contra-asset account (like accumulated depreciation, a contra-asset offsets an asset balance). In other words, if a company doesn't think it will receive the full benefit of a DTA, it can offset this with a valuation allowance in order to be more conservative. For example, a company losing tons of money will have lots of NOLs (net operating losses) as DTAs. These NOLs can be used to offset future income, which lowers taxes, a good thing. However, if the company can't reasonably expect to make a future profit, then it will never reap the benefit of those NOLs, and a valuation allowance must be set up to reflect this.

Keep a watchful eye on valuation allowances. Because they're based on very subjective estimates, they're an easy way for management to manipulate earnings. For example, if a company has a $100 million valuation allowance to offset $100 million in DTAs, and management realizes it's going to miss earnings by $2 million, it can make slightly more aggressive assumptions to release $2 million in its valuation allowance, which flows to net income and allows the company to meet earnings.

Hopefully this helped make deferred tax assets a bit clearer. Next up, we'll look at the opposite side of the balance sheet, at deferred tax liabilities. Stay tuned.

For some more accounting basics:

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Fool contributor Emil Lee is an analyst and a disciple of value investing. He doesn't own shares in any of the companies mentioned above. Emil appreciates comments, concerns, and complaints. The Motley Fool has a disclosure policy.

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