Journal Entries for Deferred Tax Assets

There can be the following scenario of deferred tax asset:

  • If book profit is lesser than taxable profit. Then deferred tax assets get created.If, as per books, there is a loss in accounts, but as per income tax rules, the company shows a profit, then the tax has to be paid and will come under deferred tax assets that can be used for future year tax payment.

Examples of Deferred Tax Asset Journal Entries

Let’s assume your company has bought an asset for $30,000, which can be depreciated in books in a straight line manner in 3 years with no salvage valueSalvage ValueSalvage value or scrap value is the estimated value of an asset after its useful life is over. For example, if a company’s machinery has a 5-year life and is only valued $5000 at the end of that time, the salvage value is $5000.read more. But due to some tax rules, this asset can be fully depreciated in year one itself for tax purposes. So let’s say the tax rate is 30%, and for the next three years, EBITDA is $50,000 per year.

In year 1:

  • EBITDAEBITDAEBITDA refers to earnings of the business before deducting interest expense, tax expense, depreciation and amortization expenses, and is used to see the actual business earnings and performance-based only from the core operations of the business, as well as to compare the business’s performance with that of its competitors.read more = $50,000Depreciation as per books = 30,000/3 = $10,000Profit Before TaxProfit Before TaxProfit before tax (PBT) is a line item in a company’s income statement that measures profits earned after accounting for operating expenses like COGS, SG&A, depreciation & amortization, and non-operating expenses. It gives the overall profitability and performance of the company before making payments in corporate taxes.read more as per books= 50000-10000 = $40,000Tax as per books = 40000*30% = $12,000

But as per tax rule, this asset can be depreciated fullyAsset Can Be Depreciated FullyFully depreciated assets are the assets that can no longer be depreciated for accounting or tax purposes. It implies that the entire depreciation has been provided in the accumulated depreciation account. These assets continue to be a part of the balance sheet unless they are sold or destroyed.read more in the first years.

  • So As per tax rules Profit before tax = 50000-30000 = $20,000Actual tax paid = 20,000*30% = $6,000

Because of tax and accounting rulesAccounting RulesAccounting rules are guidelines to follow for registering daily transactions in the entity book through the double-entry system. Here, every transaction must have at least 2 accounts (same amount), with one being debited & the other being credited. read more the first year your company has shown more tax but paid the lesser tax that means it has created deferred tax liability in its book for year 1

  • Deferred tax liabilityDeferred Tax LiabilityDeferred tax liabilities arise to the company due to the timing difference between the accrual of the tax and the date when the company pays the taxes to the tax authorities. This is because taxes get due in one accounting period but are not paid in that period.read more in year 1 = 12000-6000 = $6,000

The following journal entry must be passed in year 1 to recognize the deferred taxDeferred TaxDeferred Tax is the effect that occurs in a firm as a result of timing differences between the date when taxes are actually paid to tax authorities by the company and the date when such tax is accrued. Simply put, it is the difference in taxes that arises when taxes due in one of the accounting period are either not paid or overpaid.read more:

In year 2:

  • Tax as per books should be same = $12,000

But in actuals, you have depreciated the whole asset in year 1, so in the second year.

  • Actual tax paid = 50,000*30% = $15,000

As we can see in Y2 actual tax paid is more than the tax payable in books that means

  • Deferred tax asset in Y2 = 15,000 -12,000 =$3,000

The following journal entry must be passed in year 2 to recognize the deferred tax asset:

Year 3 –

Same way in year 3 also:

  • Deferred tax asset = $3,000

The following journal entry must be passed in year 3 to recognize the deferred tax:

Now, if you see in these three years total deferred tax liability = $6,000 and total deferred tax asset = $3,000+$3,000 = $6,000 hence in the life of the asset deferred tax asset and deferred tax liability has nullified each other.

Microsoft Deferred Income Tax Statement

Microsoft Corp is a US multinational companyMultinational CompanyA multinational company (MNC) is defined as a business entity that operates in its country of origin and also has a branch abroad. The headquarter usually remains in one country, controlling and coordinating all the international branches. read more headquartered in Washington. It is in developing, manufacturing, and licensing software such as Microsoft Office. As per the 2018 annual report, its yearly revenue is $110.4 Bn.

Below is the screenshot of its deferred tax asset and liabilities statement. As we can see, Deferred Tax Asset has been generated mostly from “Accruals RevenueAccruals RevenueAccrued revenues are the company’s revenue in the normal course of business after selling the goods or providing services to a third party. However, the payment has not been received. Instead, it is shown as an asset in the balance sheet of the company.read more” and “Credit Carryforwards.” The main source of Deferred tax liabilities is Unearned RevenueUnearned RevenueUnearned revenue is the advance payment received by the firm for goods or services that have yet to be delivered. In other words, it comprises the amount received for the goods delivery that will take place at a future date.read more. From 2017 to 2018, Net Deferred tax assets have been increased from -5,486 million to $828 million.

Source: https://www.microsoft.com

Source: https://ir.aboutamazon.com

Advantages

  • It is legal for a company to show different accounts for tax and accounting purposes. So, using this deferred tax functionality, a company can pay less taxes when it sees a lesser profit and defer the tax payment for the coming years when profit will increase.

Disadvantages

  • Deferred tax assets journal entry can affect company cash flowsCompany Cash FlowsCash Flow is the amount of cash or cash equivalent generated & consumed by a Company over a given period. It proves to be a prerequisite for analyzing the business’s strength, profitability, & scope for betterment. read more in future years. So, a company will have to use this keeping future cash in mind.While studying a financial report of the companyFinancial Report Of The CompanyFinancial reporting is a systematic process of recording and representing a company’s financial data. The reports reflect a firm’s financial health and performance in a given period. Management, investors, shareholders, financiers, government, and regulatory agencies rely on financial reports for decision-making.read more, an investor can get fooled by looking at the company’s net income without looking at the effect of deferred tax assets and liabilities.Though it is legal, companies may employ some illegal ways to take advantage of its features.

Conclusion

While understanding and applying deferred tax assets or liabilities, companies and investors need to analyze and understand the future cash flow effect. Future cash flow can be affected by deferred tax assets or liabilities. If a deferred tax liability increases, that means it is a source of cash and vice versa. So, analyzing this deferred tax helps assess where the balance is moving forward.

This has been a guide to the Deferred Tax Asset Journal Entry. Here we discuss how to recognize deferred tax assets and examples and journal entries. You can learn more about accounting from the following articles –

  • Examples of Deferred RevenueNet Operating LossDeferred Revenue ExpenditureDeferred Expenses Definition