Understanding Deferred-Tax Assets

By Lee SamahaFool.com

Deferred-tax assets are created when a company's recorded income tax (what it reports in its income statement) is lower than that paid to the tax authority. It's usually a good thing to find on a balance sheet, because the company could receive a future tax benefit from it. In other words, if you're looking at two otherwise identical companies, the one with the deferred-tax asset is more attractive, because it could pay relatively less tax in future. Let's look in more detail and use a simple example to explain the concept.

Deferred-tax assets creationAt this point, readers might wonder how a company's recorded income tax could be less than it pays to the authority. In the words of the organization responsible for accounting standards in the U.S., the Financial Accounting Standards Board, or FASB: "Tax laws often differ from the recognition and measurement requirements of financial accounting standards."

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If the difference between the tax laws (used to measurewhat thecompany will pay in tax)and accounting standards (used to define whatthe company reports in tax)result in a company paying more tax than it records, a deferred-taxasset (representing the difference) is created.

You could think of it as a kind of pre-paid tax, which the company might be able to use toreduce its tax bill in future. Examples of how temporary differences between tax laws and accounting standardscan occur include net operating losses, warranties, and the timing of recognition of expenses.

Still confused? I'll work through a commonexample.

Reported taxA trading companyobtains a batch of consumer electronics products, which it sells with a one-year warranty. Naturally, the company will expectto incur some expenses, assome products will be returned under warranty. Consequently, management estimates that its warranty expense will be 5% of its sales.

It sells $2 million worth of products ina year at a pre-tax profit margin of 50%, so pre-tax income is $1 million.Its warranty expenseis 5% of $2 million, or $100,000.

Therefore the company's income statement will show taxable income of $900,000 (pre-tax income of $1 millionminus the assumed warranty expense of $100,000). Assuming a 35% tax rate, thismeans its recorded tax (income statement) will be 35% of $900,000, or $315,000.

Tax paid Now let's deal with the tricky bit. The figure of $315,000 represents the tax from recorded income, but it's not necessarily the same as the figure paid to -- in this case -- the IRS.

The IRSdoesn't allow companies to deduct expenses for warranties until the warranty event has occurred. Therefore the tax paid to the IRS will be 35% of $1 million, or $350,000, rather than the $315,000 figure in the recorded income statement. In other words, theIRS took $35,000 more than the company recorded on its income statement.

The $35,000 then goes onto the balance sheet as a deferred-tax asset. Why is this useful, and what happens next?

Using a deferred-tax assetIn the following year, the company earns $1.2 million in pre-tax income from, say,selling mobile phone accessories (without anywarranties).Therefore its tax bill is $420,000 (35% of $1.2 million). Meanwhile, some of the products sold last year under warranty are beingreturned. In other words, the warranty event has occurred, and the company can receive the benefit of the deferred-tax asset.

Recall that it has a deferred-tax asset of $35,000, which it uses to reduce its tax billfrom $420,000 to$385,000. In this way, its taxes are reduced by using the deferred-tax asset from the previous year.

What it means to an investorIt'sa good ideato keep an eye out for deferred-tax assets, because they can help you identify a company that could pay a lower tax rate in future years. For example, in the scenario above, the company's tax rate is 32.1% ($385,000 divided by $1.2 million) in its second year, compared to the 35% reported inthe previous year. Being able to spot such situations isa useful skill for an investor.

The article Understanding Deferred-Tax Assets originally appeared on Fool.com.

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