Deferred tax asset arises when differences exist between the taxable income and actual income of a company. In other words, it is the amount of money the IRS owes to you because your taxable income was higher than your actual income for a particular accounting period.
Hence, you paid higher taxes than you reported on your books as per the accrual system.
Usually, the tax authorities have a different set of rules for the calculation of taxable income. It calculates the taxable income on a cash basis, irrespective of the matching concept of accounting, and the tax is then charged at such taxable income.
This amount of tax calculated on cash income is the income tax expense payable for the year. The tax expense incurred on actual accounting income is referred to as the current tax expense for the year and is reported on the income statement.
The variation arises due to time differences in expenses or incomes. For example, accounts payable (credit purchases) of the year would be added back into actual income to arrive at taxable income, causing the taxable income to be higher than the actual income.
The tax charged would be higher than the current tax expense for the year due to a deductible temporary difference.
However, when in the future, the company actually settles the creditors’ debts, the deferred tax shall be recovered as the creditor’s balance will be deducted from the taxable income.
Income tax payable is calculated as follows:
|(+/-) Temporary differences||xx/(xx)|
|(+/-) Permanent differences||xx/(xx)|
|Tax rate||X %|
|Income tax payable||xx|
Hence, a deferred tax asset arises when the tax payable is higher than the tax expense incurred by the company. It is the excess amount of cash paid to the government in the name of tax.
The journal entry passed to record deferred tax asset is as follows:
Deferred Tax Asset Dr
Current Tax Expense (accounting profit*tax rate) Dr
Income Tax Payable (taxable income*tax rate) Cr
Reasons why the deferred tax asset arises:
- A deferred tax asset would arise when the depreciation method, as per tax laws, is a straight line, whereas you have used a double depreciation method in your books of accounts. As the double depreciation method charges higher depreciation in initial years, the accounting income is lower than the taxable income resulting in a deferred tax asset.
- When a higher depreciation rate for your books is used than the tax laws’, a higher depreciation is charged on the accounts. In contrast, a lower depreciation is charged to the taxable income.
- Accrued expenses such as rent payable may also cause a deferred tax asset. Rent incurred is deducted on the income statement, whereas on the tax statement, only rent paid is deducted; hence, causing a deferred tax asset.
- When an advance income is received, it is included in the tax statement and not on the income statement. Hence, the accounting profit is lower, and the taxable profit is higher; a deductible temporary difference results in a deferred tax asset.
- Provision for bad debt is a line item of the income statement, whereas it is not considered expenditure under the tax laws and is added back. Hence the taxable income is higher than the accounting income resulting in deferred tax assets.
ABC Company has bought machinery for $50,000. It depreciates its assets at the rate of 20% per annum, whereas the tax laws allow depreciation at 10% per annum.
It also has a net profit of $80,000 for the current year and a 30% tax rate.
|(+) Accounting depreciation||10,000|
|(-) Tax depreciation||(5,000)|
|Income Tax payable||25,500|
Dr Current Tax Expense ($80,000*30%) $24,000
Dr Deferred Tax Asset $1,500
Cr Income Tax Payable ($85,000*30%) $25,500