Deferred tax assets, along with deferred tax liabilities, are accounting concepts under both U.S. generally accepted accounting principles, or GAAP, and international financial reporting standards, or IFRS. Deferred tax assets and deferred tax liabilities develop as a result of differences in the income tax reporting standards and the financial reporting standards of business entities.
Basis of Accounting
Most large business entities must track their accounting records under a minimum of two separate bases of accounting. While they must typically use a nationally accepted accounting standard, such as a national GAAP or IFRS, when preparing a formal set of financial statements for use by stakeholders, they are also required by taxing authorities to maintain a set of accounting records under the statutory basis required for income tax reporting. Often, the statutory basis of accounting used for income tax reporting may differ greatly from the basis of accounting used for financial reporting.
The differences between the pre-tax net income reported for financial reporting purposes and the taxable income reported to taxing authorities, such as the Internal Revenue Service, give rise to both deferred taxes and deferred liabilities. When an entity’s future taxable income will be less than future book, or financial reporting, income, it gives rise to what is known as deferred tax asset, as the taxable income that has been previously indicated under financial reporting standards has been greater than the income previously indicated under tax statutory reporting standards. Conversely, when future taxable income will be less than future book income, it is known as a deferred tax liability.
Conceptually, deferred tax assets and deferred tax liabilities can be difficult to understand. It helps to illustrate these with an example. Imagine a calendar year reporting entity that reports under the cash basis of accounting for tax reporting and the accrual basis of accounting for income tax reporting. On December 31, the company makes a sale for which it will recognize $100 of net income and receives the money on January 3. For financial reporting purposes, net income will be $100 greater than for tax reporting purposes. Income tax expense for financial reporting purposes will be higher than the amount actually paid for income tax purposes. This difference in tax paid is the deferred tax asset.
Deferred tax assets and liabilities are calculated based on an entity’s effective tax rate -- typically the marginal rate is used -- based on currently enacted income tax laws. This rate is then multiplied by the gross difference in income between reporting bases. In the prior example, the gross difference in reporting base was $100. If the company’s effective marginal tax rate for future income, based on currently enacted tax laws, was 25 percent, the company’s deferred income tax asset would be $25, or 25 percent times $100.