Deferred tax assets and liabilities
A deferred tax liability is tax postponed to later; a deferred tax asset is tax paid early or a future deduction. Income tax expense = taxes payable + increase in DTL − increase in DTA. Analysts check whether DTAs will really be used and whether DTLs will ever be paid.
Before this: Accounting profit vs taxable income: temporary and permanent differences
On the exam
- Explain how deferred tax liabilities and assets are created and the factors that determine how a company’s deferred tax liabilities and assets should be treated for the purposes of financial analysis
Explain how DTLs and DTAs are created and how to treat them in analysis. Expect the tax expense equation, a tax rate change effect, a valuation allowance item and a 'liability or equity' judgment.
How deeply to learn each part
- Know the idea
- Understand it in general. It frames other topics, but you will not calculate with it.
- Use it
- Understand it well enough to solve a question with it. Recognize when it applies.
- Memorize
- Learn it by heart. The exam will not give it to you.
You know this one. The full lesson is folded away. The takeaways, formulas and checkpoint below are your quick refresher, and the checkpoint is a fair test of whether you still do.
You tested strong here. The full lesson is folded away. The takeaways, formulas and checkpoint below are your quick refresher, and the checkpoint is a fair test of whether you still know it.
How do deferred tax liabilities and assets arise?
A deferred tax liability arises when tax is postponed: the accounts have recognized profit that the tax return has not yet taxed, so more tax is owed later. A deferred tax asset arises when tax is paid early or a deduction is still to come, so less tax is owed later.
- Deferred tax liability Memorize tax postponed: more tax to pay later
- Faster depreciation for tax deduction taken early
- Income recognized in the accounts before it is taxed installment sales, fair value gains
-
- Deferred tax asset Memorize tax paid early or a deduction still to come
- Expense accrued before it is deductible warranties, bad debts
- Cash taxed before it is earned unearned revenue
- Tax loss carryforward losses that will shelter future profits
-
Every period the company recomputes each balance by comparing carrying amounts with tax bases (previous lesson). The changes in those balances flow into the income statement.
An unused tax loss is the other big source of DTAs. A tax loss carryforward will shelter future profit, so it is an asset, but only if the company is likely to earn that profit.
What is the income tax expense equation?
Income tax expense equation : expense is taxes payable plus the change in deferred taxes. First the bill (taxes payable), then the adjustment for what has been deferred.
Taxable income is 950.00 and the tax rate is 25.00%. Income tax payable is closest to:
950.00 × 25.00% = 237.50
Income tax payable237.50
- 950×0.25=
- 950ENTER0.25×
ENTER enter (on the HP, puts the number on the stack)
Income tax payable is 237.50. During the year the deferred tax liability changed by 37.50 (an increase is positive) and the deferred tax asset changed by 20.00 (an increase is positive). Income tax expense is closest to:
237.50 + 37.50 − 20.00 = 255.00
Income tax expense255.00
- 237.5+37.5−20=
- 237.5ENTER37.5+20−
ENTER enter (on the HP, puts the number on the stack)
Try this 0 of 3
- Cut the future tax rate and see tax expense fall
- Make the DTA bigger than the DTL, then cut the rate
- Add a valuation allowance of at least half the DTA
Pretax income 1,000. This year's rate 25%.
- Pretax income (accounts)1,000.0
- Extra tax depreciationtemporary → DTL−150.0
- Warranty accrual added backtemporary → DTA+80.0
- Fine added backpermanent, no deferred tax+20.0
- Taxable income950.0
| Taxes payable (25% × 950.0) | 237.5 |
|---|---|
| + Increase in DTL (25% × 150.0) | 37.5 |
| − Increase in DTA (25% × 80.0) | (20.0) |
| Income tax expense | 255.0 |
Show working
Taxable income = 1,000 − 150 + 80 + 20 = 950.0; taxes payable = 25% × 950.0 = 237.5
Tax expense = taxes payable + ΔDTL − ΔDTA = 237.5 + 37.5 − 20.0 = 255.0
Check: 25% × (pretax 1,000 + permanent 20) = 255.0 = 255.0
- 950×0.25+(150×0.25)−(80×0.25×1)=255
- 950ENTER0.25×150ENTER0.25×+80ENTER0.25×1×−255
ENTER enter (on the HP, puts the number on the stack)
Exam tip Increases in DTL add, increases in DTA subtract. Decreases do the opposite. A question that gives you a DTL “decrease” of 20 means you add −20.
What happens when the tax rate changes?
Use it
A tax rate change forces a remeasurement. Deferred taxes are valued at the enacted rate expected when they reverse, so both DTLs and DTAs rescale. A cut shrinks both. The DTL shrinking is good news (less owed) and lowers tax expense. The DTA shrinking is bad news (a smaller future saving) and raises it. A rate rise does the reverse.
A company has a taxable temporary difference of 150.00. The tax rate changes from 25.00% to 20.00%. The deferred tax liability at the new rate is closest to:
150.00 × 20.00% = 30.00
Deferred tax balance at the new rate30.00
- 150×0.2=
- 150ENTER0.2×
ENTER enter (on the HP, puts the number on the stack)
Will the deferred tax asset be used?
Memorize
A DTA is only worth something if the company will earn taxable profit to use it. Realizability is the test: under International Financial Reporting Standards (IFRS) recognition needs future taxable profit to be probable, and under US generally accepted accounting principles (US GAAP) the asset is recognized if realization is more likely than not (above 50%).
If part of the asset is doubtful, IFRS reduces the DTA directly. US GAAP keeps the gross DTA and subtracts a valuation allowance , a contra asset. Either way the write-down is a charge in tax expense, and a later release is a boost to profit.
- Yes recognize the DTA in full
- No: part of the DTA is doubtful Memorize
- IFRS Memorize reduce the DTA directly
- US GAAP Memorize keep the gross DTA and book a valuation allowance (contra asset)
-
A company has a gross deferred tax asset of 200.00, and 40.00% of it is not more likely than not to be realized. Under US GAAP the valuation allowance is closest to:
200.00 × 40.00% = 80.00
Valuation allowance80.00
- 200×0.4=
- 200ENTER0.4×
ENTER enter (on the HP, puts the number on the stack)
The allowance rests on management’s forecast of future profit, so it is an earnings lever. Reporting quality covers the pattern: a large allowance release in a good year flatters profit.
Should an analyst treat a deferred tax liability as debt?
Deferred taxes as liability or equity is an analyst’s judgment: will the tax ever be paid? A DTL that is expected to reverse and be settled is a liability. One that never reverses, perhaps because a growing asset base keeps tax depreciation ahead of book depreciation, will never cost cash, so treat it as equity.
- Expected to reverse and be paid Use it treat as a liability
- Not expected to reverse Use it treat as equity, e.g. capex keeps growing
- Timing and amount uncertain Use it leave out of both liabilities and equity
Reclassifying a DTL as equity lowers the debt-to-equity ratio. Deferred taxes are non-current items on the balance sheet under both IFRS and US GAAP.
Go deeper Why a DTL can keep growing
If a company keeps buying equipment, each year’s new accelerated deductions can outweigh the reversal of old differences. The DTL balance then stays flat or grows for as long as the company keeps investing. That is why analysts often treat it as quasi-equity for a growing company, and as a liability for a company that is shrinking or winding down.
Go deeper Loss carryforwards and expiry
A tax loss carryforward can have an expiry date or an annual cap under local law. A large carryforward on a company that is back to profit lowers future cash taxes, and it can be valuable to a profitable acquirer, which could use it against its own profits. The value is the present value of the tax saved, at the acquirer’s tax rate and timing.
Memorize this
MemorizeTax expense equation
| Item | Effect on income tax expense |
|---|---|
| Taxes payable | Starting point (the current tax) |
| Increase in DTL | Adds (more tax owed later, charged now) |
| Increase in DTA | Subtracts (tax prepaid, a credit) |
Memory hook Expense = the bill + what you will owe later − what you have prepaid. A liability adds, an asset subtracts, like a bill with a rebate.
Know it cold Income tax expense = taxes payable + ΔDTL − ΔDTA. Decreases flip the sign: a falling DTL lowers the expense.
MemorizeTax rate change
| Rate | DTL | DTA | Effect on expense |
|---|---|---|---|
| Cut | Falls | Falls | DTL fall lowers expense; DTA fall raises it |
| Rise | Rises | Rises | DTL rise raises expense; DTA rise lowers it |
Memory hook Both balances scale with the rate. Shrinking what you owe is a gain; shrinking what you were owed is a loss.
Know it cold Remeasure at the enacted rate in force when the item reverses. A net DTL company gains from a cut; a net DTA company loses.
MemorizeDoubtful deferred tax assets
| Recognize if | Doubt arises | |
|---|---|---|
| IFRS | Future taxable profit is probable | Reduce the DTA directly |
| US GAAP | More likely than not (above 50%) to be realized | Valuation allowance, a contra asset |
Memory hook US GAAP "keeps both books": gross DTA plus an allowance. IFRS has one number. Both mean the same earnings hit.
Know it cold Raising the allowance (or writing down the DTA) increases tax expense and cuts profit; releasing it boosts profit. It is a management judgment.
- Deferred tax liability Memorize tax postponed: more tax to pay later
- Faster depreciation for tax deduction taken early
- Income recognized in the accounts before it is taxed installment sales, fair value gains
-
- Deferred tax asset Memorize tax paid early or a deduction still to come
- Expense accrued before it is deductible warranties, bad debts
- Cash taxed before it is earned unearned revenue
- Tax loss carryforward losses that will shelter future profits
-
- Yes recognize the DTA in full
- No: part of the DTA is doubtful Memorize
- IFRS Memorize reduce the DTA directly
- US GAAP Memorize keep the gross DTA and book a valuation allowance (contra asset)
-
- Expected to reverse and be paid Use it treat as a liability
- Not expected to reverse Use it treat as equity, e.g. capex keeps growing
- Timing and amount uncertain Use it leave out of both liabilities and equity
Quick example
Taxable income of 1,200 at a 30% tax rate: 1,200 × 0.30 = 360 of income tax payable.
- 1200×0.3= 360
- 1200ENTER0.3× 360
ENTER enter (on the HP, puts the number on the stack)
Quick example
Taxes payable are 640. The DTL fell by 30 and the DTA rose by 12. Expense = 640 + (−30) − 12 = 598.
- 640+30+|-−12= 598
+|- change sign
- 640ENTER30CHS+12− 598
ENTER enter (on the HP, puts the number on the stack) · CHS change sign
Quick example
A taxable temporary difference of 400 and a rate cut from 30% to 24%. 400 × (24% − 30%) = −24: the DTL falls by 24, and tax expense falls by 24.
- 24−30=×400÷100= −24
- 24ENTER30−400×100÷ −24
ENTER enter (on the HP, puts the number on the stack)
Quick example
A gross DTA of 350 of which 30% is unlikely to be used. VA = 350 × 0.30 = 105; net DTA = 245.
- 350×0.3= 105
- 350ENTER0.3× 105
ENTER enter (on the HP, puts the number on the stack)
How it is asked
-
Tax expense equation
Taxes payable 430, DTL up 35, DTA up 20. Income tax expense?
430 + 35 − 20 = 445. Reversing both signs (415) and adding both (485) are the traps.
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Rate cut
Government cuts the corporate rate. Company has a large net DTL. Effect on tax expense?
The DTL is remeasured down, so expense is lower (a one-off gain). A company with a net DTA would see the opposite.
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Valuation allowance
US GAAP company judges part of a DTA unlikely to be used. Treatment?
Valuation allowance, which raises tax expense. IFRS reduces the asset directly; it has no allowance account.
-
Debt or equity?
A DTL that the company does not expect to pay because capex keeps growing. How should the analyst treat it?
As equity: no cash outflow is expected. Treat as a liability only if it will reverse.
Exam traps
- Adding ΔDTA instead of subtracting it. A rising DTA lowers the tax expense.
- Saying a rate cut increases a DTL. A cut shrinks both DTLs and DTAs.
- Saying IFRS uses a valuation allowance. That is US GAAP; IFRS reduces the DTA directly.
- Treating every DTL as debt. If it will never reverse, treat it as equity.
Checkpoint
3 exam-style questions. About 90 seconds each.
1Income taxes payable are EUR 520k. During the year the deferred tax liability increased by EUR 45k and the deferred tax asset increased by EUR 15k. Income tax expense is closest to:
2A government cuts the corporate tax rate. For a company with a large net deferred tax liability, the immediate effect is most likely:
3Under US GAAP, when it becomes more likely than not that part of a deferred tax asset will not be realized, the company:
Key takeaways
- Income tax expense = taxes payable + ΔDTL − ΔDTA.
- A rate change remeasures DTLs and DTAs; a cut lowers the expense for a DTL and raises it for a DTA.
- Doubtful DTA: US GAAP valuation allowance, IFRS direct reduction. Both raise expense and cut profit.
- A DTL that will never reverse is closer to equity than debt.
Quick example
Taxable income of 1,200 at a 30% tax rate: 1,200 × 0.30 = 360 of income tax payable.
- 1200×0.3= 360
- 1200ENTER0.3× 360
ENTER enter (on the HP, puts the number on the stack)
Quick example
Taxes payable are 640. The DTL fell by 30 and the DTA rose by 12. Expense = 640 + (−30) − 12 = 598.
- 640+30+|-−12= 598
+|- change sign
- 640ENTER30CHS+12− 598
ENTER enter (on the HP, puts the number on the stack) · CHS change sign
Quick example
A taxable temporary difference of 400 and a rate cut from 30% to 24%. 400 × (24% − 30%) = −24: the DTL falls by 24, and tax expense falls by 24.
- 24−30=×400÷100= −24
- 24ENTER30−400×100÷ −24
ENTER enter (on the HP, puts the number on the stack)
Quick example
A gross DTA of 350 of which 30% is unlikely to be used. VA = 350 × 0.30 = 105; net DTA = 245.
- 350×0.3= 105
- 350ENTER0.3× 105
ENTER enter (on the HP, puts the number on the stack)
Questions about this lesson?
Where this comes back
- Effective, statutory and cash tax rates Analysis of Income Taxes
- Financial Reporting Quality Financial Statement Analysis
Questions candidates ask
How do you calculate income tax expense with deferred taxes?
Income tax expense = taxes payable + increase in deferred tax liability − increase in deferred tax asset. Taxes payable of 310 with a DTL up 25 and a DTA up 10 gives 310 + 25 − 10 = 325. A decrease in either item reverses its sign.
What is a valuation allowance?
Under US GAAP, a contra-asset account that reduces a deferred tax asset to the amount more likely than not to be realized. Increasing it raises tax expense; releasing it lowers expense and boosts profit. IFRS reduces the asset directly instead.
Should a deferred tax liability be treated as debt or equity?
It depends on whether it will be paid. If it is expected to reverse and be settled in cash, treat it as a liability. If it is not expected to reverse (for example because capital spending keeps growing), treat it as equity. If timing and amount are uncertain, leave it out of both.
What happens to deferred taxes when the tax rate changes?
Both DTLs and DTAs are remeasured at the new enacted rate. A rate cut shrinks each: the DTL fall lowers tax expense, the DTA fall raises it. A rate rise does the reverse. The effect is recorded in income tax expense in the period of the change.
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