Deferred-tax assets are created when a company's recorded income tax (what it reports in its income statement) is lower than that paid to the tax authority. It's usually a good thing to find on a balance sheet, because the company could receive a future tax benefit from it. In other words, if you're looking at two otherwise identical companies, the one with the deferred-tax asset is more attractive, because it could pay relatively less tax in the future. Let's look in more detail and use a simple example to explain the concept.
Deferred-tax assets creation
At this point, readers might wonder how a company's recorded income tax could be less than it pays to the authority. In the words of the organization responsible for accounting standards in the U.S., the Financial Accounting Standards Board, or FASB: "Tax laws often differ from the recognition and measurement requirements of financial accounting standards."
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If the difference between the tax laws (used to measure what the company will pay in tax) and accounting standards (used to define what the company reports in tax) result in a company paying more tax than it records, a deferred-tax asset (representing the difference) is created.
You could think of it as a kind of pre-paid tax, which the company might be able to use to reduce its tax bill in future. Examples of how temporary differences between tax laws and accounting standards can occur include net operating losses, warranties, and the timing of recognition of expenses.
Still confused? I'll work through a common example.
Reported tax
A trading company obtains a batch of consumer electronics products, which it sells with a one-year warranty. Naturally, the company will expect to incur some expenses, as some products will be returned under warranty. Consequently, management estimates that its warranty expense will be 5% of its sales.
It sells $2 million worth of products in a year at a pre-tax profit margin of 50%, so pre-tax income is $1 million. Its warranty expense is 5% of $2 million, or $100,000.
Therefore the company's income statement will show taxable income of $900,000 (pre-tax income of $1 million minus the assumed warranty expense of $100,000). Assuming a 35% tax rate, this means its recorded tax (income statement) will be 35% of $900,000, or $315,000.
Tax paid
Now let's deal with the tricky bit. The figure of $315,000 represents the tax from recorded income, but it's not necessarily the same as the figure paid to -- in this case -- the IRS.
The IRS doesn't allow companies to deduct expenses for warranties until the warranty event has occurred. Therefore the tax paid to the IRS will be 35% of $1 million, or $350,000, rather than the $315,000 figure in the recorded income statement. In other words, the IRS took $35,000 more than the company recorded on its income statement.
The $35,000 then goes onto the balance sheet as a deferred-tax asset. Why is this useful, and what happens next?
Using a deferred-tax asset
In the following year, the company earns $1.2 million in pre-tax income from, say, selling mobile phone accessories (without any warranties). Therefore its tax bill is $420,000 (35% of $1.2 million). Meanwhile, some of the products sold last year under warranty are being returned. In other words, the warranty event has occurred, and the company can receive the benefit of the deferred-tax asset.
Recall that it has a deferred-tax asset of $35,000, which it uses to reduce its tax bill from $420,000 to $385,000. In this way, its taxes are reduced by using the deferred-tax asset from the previous year.
What it means to an investor
It's a good idea to keep an eye out for deferred-tax assets, because they can help you identify a company that could pay a lower tax rate in future years. For example, in the scenario above, the company's tax rate is 32.1% ($385,000 divided by $1.2 million) in its second year, compared to the 35% reported in the previous year. Being able to spot such situations is a useful skill for an investor.
