Deferred Tax Asset Journal Entry

Suppose a company has overpaid its tax or paid advance tax for a given financial period. In that case, the excess tax paid is known as deferred tax asset and its journal entry is created when there is a difference between taxable income and accounting income.

There can be the following scenario of deferred tax asset:

1. If book profit is lesser than taxable profit. Then deferred tax assets get created.
2. 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.

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 value. 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:

• EBITDA = $50,000
• Depreciation as per books = 30,000/3 = $10,000
• Profit Before Tax as per books= 50000-10000 = $40,000
• Tax as per books = 40000*30% = $12,000

But as per tax rule, this asset can be depreciated fully in the first years.

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

Because of tax and accounting rules 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 liability in year 1 = 12000-6000 = $6,000

The following journal entry must be passed in year 1 to recognize the deferred tax:

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 Corp is a US multinational company 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 Revenue” and “Credit Carryforwards.” The main source of Deferred tax liabilities is Unearned Revenue. From 2017 to 2018, Net Deferred tax assets have been increased from -5,486 million to $828 million.

Source: https://www.microsoft.com

Amazon is an American multinational based in Washington. The primary focus of Amazon is in e-commerce, cloud computing, and artificial intelligence. As per the 2018 annual report,  its annual revenue is $233 Bn. Below is the screenshot of Amazon’s Deferred Tax Asset and Deferred Tax liabilities statement. The Main Sources for deferred tax assets are Loss Carryforward and Stock-Based compensation. “Depreciation and amortization” are the main source of deferred tax liabilities. From 2017 to 2018, net Deferred tax liabilities increased from $197 M to $544M.

Source: https://ir.aboutamazon.com

• 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.

• Deferred tax assets journal entry can affect company cash flows in future years. So, a company will have to use this keeping future cash in mind.
• While studying a financial report of the company, 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.

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 Revenue
• Net Operating Loss
• Deferred Revenue Expenditure
• Deferred Expenses Definition