Deferred Tax Assets and Liabilities
Companies keep two sets of rules: accounting rules for shareholders and tax rules for governments. Timing differences between them create deferred taxes.
Why this matters for beginners
Deferred taxes explain gaps between reported tax and cash tax, and can hide future bills or future savings. Learning objectives: tell deferred tax assets from liabilities and judge their quality.
Main explanation
Tax expense in the income statement is based on accounting profit. Cash tax is based on taxable profit under tax law. The two often differ in timing.
A deferred tax liability arises when a company pays less tax now and more later, for example when tax rules allow faster depreciation than the accounts use.
A deferred tax asset arises when a company pays more tax now or can pay less later, most commonly from past losses it can offset against future profits.
Deferred tax assets from losses only have value if the company becomes profitable. Companies write them down with a valuation allowance when future profits look doubtful.
A steadily growing deferred tax liability in a growing company can behave like an interest-free loan from the government that may rarely be repaid in full.
Example using a real company
A capital-heavy company such as a railroad or utility often carries large deferred tax liabilities from accelerated tax depreciation.
- →Accounting depreciation 100, tax depreciation 160: taxable profit is 60 lower, creating a deferred tax liability.
- →A start-up with 500 of past losses records a deferred tax asset it can use once profitable.
Common beginner mistakes
- ✕Assuming reported tax expense equals cash paid.
- ✕Treating loss-based tax assets as certain value.
- ✕Ignoring sudden valuation allowances as a warning sign.
Key terms
- Deferred tax liability
- Tax postponed to future periods because of timing differences.
- Deferred tax asset
- Future tax reductions, often from past losses or prepaid tax.
- Valuation allowance
- A write-down of deferred tax assets unlikely to be used.
Key takeaways
- 01Reported tax and cash tax often differ.
- 02Liabilities postpone tax; assets reduce future tax.
- 03Loss-based assets depend on future profits.
Check yourself
- 01Why do deferred taxes exist?
- 02What commonly creates a deferred tax liability?
- 03What commonly creates a deferred tax asset?
- 04When does a deferred tax asset from losses lose value?
- 05What does a large valuation allowance signal?
Try the concept on a real company
Open a capital-heavy company in the Analyzer and compare its tax expense with cash taxes paid.
Educational examples only. Not buy or sell recommendations.