Deferred Tax Asset Journal Entry

Do you want to know how companies effectively manage their taxes? The Tax Policy Center points out that as much as 50% of the firms with deferred tax assets fail to utilize them, thereby missing out on the potential tax savings. This aspect is crucial to accountants and business owners in ensuring that they’re maximizing their tax benefits. 

Contents:

What are deferred tax assets? 

A deferred tax asset is a financial item shown on a company’s balance sheet, which means future tax savings. It arises from a firm’s overpayment of taxes or losses for which it can compensate by using future tax liabilities. Any accounting professional or business owner must know how these assets arise and are recorded. Let’s take a look at it.

How deferred tax assets arise 

Several scenarios can give rise to these taxes: 

Net operating losses (NOLs)

Companies that experience losses in one tax period can carry these losses forward to offset taxable income in the next periods. This carryforward can help lower tax liabilities when the company becomes profitable again. 

Assume some company incurs a loss of $100,000 in 2023; such a carried loss can be brought forward to offset the taxable income for the years ahead. Now imagine that in 2024, the company realizes a profit of $150,000. By applying the carried-forward loss, they reduce the income to be brought into tax to a mere $50,000: $150,000 minus $100,000.

Applying a 30% tax rate would bring their tax liability down to $15,000 as opposed to $45,000. In that light, the company will be able to significantly reduce its tax liability and subsequently achieve a good cash flow position during a profitable year.

Tax credits

Businesses can earn various tax credits, such as research and development (R&D), which can be utilized in future tax periods.  

For example, if a company invests in either developing a new product or enhancing an existing one, it may be eligible for R&D tax credits because of expenses incurred in the course of such development. If the company doesn’t owe taxes in that current year, then it may carry such credits forward to future years, providing immeasurable financial relief when those credits finally come into play after it turns a profit.

This capability to use the tax credit over numerous periods incentivizes continued innovation and enhances a company’s cash position, elevating its financial health.

Temporary differences

Certain expenses may be recognized in financial statements before they’re deductible for tax purposes.  

It may be due to various requirements in accounting and tax reporting. For example, a company could invest in employee training or research and development that is subtracted as an expense in its financial statements in this year. The Internal Revenue Code could permit the subtraction of this kind of expenses in future tax years—a temporary difference.

This difference in timing could lead to deferred tax assets. For instance, if a company has R&D expenses of $50,000 in 2023, it must immediately recognize the expense for financial reporting purposes, but can deduct that amount evenly over the next three years.

This leads us to the next critical issue—how deferred tax assets affect financial statements.

Impact on financial statements 

As you could see in the example above, the deferred tax asset is an asset of the balance sheet representing the future deduction or, in other words, the future potential saving of the company on its taxes. These are liabilities that arise from an overpayment of taxes by a firm or when it’s accrued some tax credits to be used as offset against the years in which the tax liabilities are to be paid. 

However, these benefits can only be materialized if the company generates future income. The company has to check the value of the deferred tax assets and, where applicable, write that amount off the balance sheet if a company doesn’t anticipate generating enough future income. Such checking is an effort to ensure that financial statements more accurately reflect its forecasted capability of realizing the deferred tax benefits.  

With that in mind, let’s discuss the journal entries to record deferred tax assets.

Journal entries for deferred tax assets 

Basic journal entry structure 

Recording a deferred tax asset involves a straightforward journal record. The typical structure is as follows: 

• Debit: Deferred Tax Asset (to increase the asset) 
• Credit: Income Tax Expense (to reduce the tax expense) 

Example journal entry 

For instance, if a company recognizes a $5,000 tax asset, the journal record would be: 

• Debit: Deferred Tax Asset – $5,000 
• Credit: Income Tax Expense – $5,000 

This acknowledges a $5,000 tax asset that represents future tax benefits. 

Journal entries for changes 

If projections regarding future income change, companies may need to adjust their tax deductions accordingly. 

Adjustment example 

Suppose a company revises its expectations downward by $1,000 and needs to reduce its accrued tax assets. The journal record would be: 

• Debit: Income Tax Expense – $1,000 
• Credit: Deferred Tax Asset – $1,000 

This adjustment reflects updated projections and ensures that the financial statements accurately represent the company’s tax position. 

Valuation allowance

A valuation allowance becomes appropriate when there is uncertainty about the ability of the company to generate enough future income to use the future tax benefit, in periods of economic recession, and when sales have fallen significantly or losses are mounting. For instance, a technology firm invests millions of dollars in R&D and suffers continuous net losses. It may not be able to use its deferred tax assets effectively. This enables the business to present a realistic picture of its financial situation. 

Journal entry for valuation allowance 

For example, if a company decides to create a value assessment allowance of $2,000, the record would be: 

• Debit: Income Tax Expense – $2,000 
• Credit: Valuation Allowance – $2,000 

This ensures the financial statements reflect conservative expectations regarding the asset’s realizability. 

Deferred tax liability vs. deferred tax asset 

It’s necessary to distinguish between deferred tax liabilities and deferred tax assets. A deferred tax liability arises when the payment of taxes is postponed to future periods, in a situation when income is recognized earlier in financial reporting but later in tax reporting. Conversely, a deferred tax asset is an overpayment of taxes or tax credits available for offsetting taxes payable in future periods.  

Key differences: 

• Deferred Tax Asset: Represents future tax savings. 
• Deferred Tax Liability: Represents future tax payments. 

Journal entries for future tax benefit and liability 

For a deferred tax asset: 

• Debit: Deferred Tax Asset – $3,000 
• Credit: Income Tax Expense – $3,000 

For a deferred tax liability: 

• Debit: Income Tax Expense – $4,000 
• Credit: Deferred Tax Liability – $4,000 

Understanding and adequately accounting for assets and liabilities is important for accurate financial reporting and tax compliance. 

Practical examples and scenarios 

Let’s take a deeper dive into deferred tax assets and explore some practical cases to illustrate how different situations affect their recognition and adjustments.

Example 1: Recognizing a deferred tax asset from NOLs 

Consider a firm suffers a net operating loss of $10,000 for the current year; this would be carried forward to offset future taxable income. The accounting entry on books for the above transaction would be:

• Debit: Deferred Tax Asset – $10,000 
• Credit: Income Tax Expense – $10,000 

This entry represents that the company expects to get advantage of future tax deductions due to the NOL, which will reduce its tax burden in the next profitable years.

Example 2: Adjusting for value assessment allowance 

Later, if the same company estimates that it may not be able to fully utilize the $10,000 deferred tax asset due to uncertainty in future profitability, it would need to set up a valuation allowance. For example, assuming it only expects to utilize $7,000 of the asset, the adjustment would appear as follows:

• Debit: Income Tax Expense – $3,000 
• Credit: Valuation Allowance – $3,000 

This entry represents the firm’s pragmatic approach to applying the deferred tax asset and ensures that its financial statements correctly reflect expected future benefits.

Example 3: Changes in tax rates 

Now, assume that the tax legislation has changed and decreased the corporate tax rate from 30% to 25%, which decreases the carrying value of the previously recognized deferred tax asset by $5,000. To record this decrease, the company would enter the following in its journal:

• Debit: Income Tax Expense – $1,000 
• Credit: Deferred Tax Asset – $1,000 

This entry recognizes that the potential benefit from the asset has been reduced as a result of the lower tax rate and accommodates this new tax environment on the books.

Example 4: Using deferred tax asset

Assume the company, during the subsequent year, generates $15,000 in taxable income and utilizes $10,000 of the deferred tax asset against the taxable income. The journal entry for this would be as follows:

• Debit: Income Tax Expense – $2,500 (assuming a tax rate of 25%)
• Credit: Deferred Tax Asset – $2,500

This represents the actual benefit that the company gains from the deferred tax asset and how deferred tax assets can favorably impact tax liabilities when utilized right.

Let Synder automate your bookkeeping process and enjoy seamless data transfer from all your sales and payment platforms directly to your accounting software. No more manual errors with real-time data synchronization! Synder will take the headache off your accounting tasks! Sign up for a 15-day free trial or join our Weekly Public Demo to learn more.

Best practices for recording deferred tax assets 

Effective management of deferred tax assets is required both for proper financial reporting and realization of tax benefits. Some best practices are as follows:

Regular review

Businesses should evaluate their deferred tax assets, especially tax credits and NOLs, on a quarterly basis. To do this, compare financial forecasts against the likelihood of using such assets with projected income. For instance, a company forecasted that it’ll make $200,000 in taxable income but lowered its forecast to $150,000. It may need to adjust its entries for deferred tax assets as the utilization of NOLs will be less.

Documentation and evidence

It’s very important to keep detailed records and all the documentation that supports the deferred tax asset entries. This should include, but isn’t limited to, copies of tax filings and correspondence with the tax authorities, internal projections justifying recognition of such assets. Say, a company has $50,000 in deferred tax assets from NOLs. In this case, it should keep on record, for instance, how those losses will be offset against future income to keep it compliant and support its financial position. 

Consult experts

Engaging professionals can help ensure compliance with accounting standards and optimize benefits. These professionals will assist in optimizing deferred tax strategies, such as analyzing the impact of changes in legislation or advice on creating valuation allowances. For example, if a company is considering a merger, tax advisors can evaluate how the merger might impact existing deferred tax assets and recommend adjustments to maximize potential tax benefits.

Wrap up

Accurate journal entries are pretty crucial in accounting in terms of the management of accrued tax assets. Furthermore, the journal entry helps companies know how much actual savings in taxes will be created, enhances financial planning, and complies with tax regulations. To ward off inaccuracies, best practices, with the help of tax experts, ensure companies retain accurate financial books. So, let’s keep those books in perfect shape for a brighter financial future!