Chapter 6 of 6 · 12 min

Deferred tax assets and losses carried forward

When losses today cut tax tomorrow: the asset, how it unwinds, and when to write it down.

By the end of this chapter you can

Size a deferred tax asset from net operating losses
Separate book tax expense from cash tax paid when losses are used
Walk a valuation allowance through the statements
Work out how much loss was used from the gap between book tax and cash tax

The intuition

A start-up loses $100 million in its early years. Tax rules let it carry those losses forward: once it makes money, it can subtract the old losses from its taxable income. At a 25% tax rate, those losses will save $25 million of future tax.

That future saving is worth something, so the balance sheet records it as a deferred tax asset of $25 million. It is not cash yet. It turns into cash only as the company earns profits and pays less tax than it otherwise would.

The key idea

The income statement charges tax on this year's profit as if the losses did not exist. The cash tax bill is lower. The gap between the two is the deferred tax asset unwinding.

Why it works

Size. Deferred tax asset = net operating losses (NOLs) × tax rate.
Using the losses. Book tax expense is pre-tax income × t, as normal. The company uses losses up to its income: NOL used is the smaller of this year's income and the losses available. Cash tax = (income − NOL used) × t.
The gap goes through cash flow. Net income was charged more tax than was paid, so the difference is added back in cash from operations, and the deferred tax asset shrinks by the same amount.
Valuation allowance. If the company may never earn enough to use the losses, it writes the asset down with a valuation allowance: a non-cash increase in tax expense. Net income falls, the net deferred tax asset falls, and cash does not move.
Tax rate changes. The asset is losses × rate, so a rate cut shrinks it. The remeasurement goes through tax expense in the year of the change, with no cash effect.

$100 of losses at 25%, then $60 of pre-tax income

Deferred tax asset: 100 × 25%	25.0
Book tax expense: 60 × 25%	15.0
Losses used: the smaller of 60 and 100	60.0
Cash tax paid: (60 − 60) × 25%	0.0
Deferred tax asset unwinds: 15 − 0	15.0
= Deferred tax asset left, with $40 of losses remaining	10.0

The formulas

DTA = NOL × t

The future tax the losses will save.

NOL used = min(pre-tax income, NOL)

You cannot use more loss than you have income to shelter.

Book tax expense = pre-tax income × t

The income statement ignores the losses.

Cash taxes paid = (pre-tax income − NOL used) × t

The bill the losses actually reduce.

DTA unwinds by NOL used × t

Exactly the gap between book tax and cash tax.

Valuation allowance: Δ tax expense +A, Δ net income −A, Δ cash 0, Δ net DTA −A

Writing the asset down is a non-cash charge through tax.

Rate cut t → t2: Δ DTA = −NOL × (t − t2) = Δ net income, no cash

The same losses shelter less tax, so the asset is worth less.

Worked example

Two tax numbers for the same year. Work out the one the income statement shows, then the one the company pays.

Drawing the numbers…

See it move

Same company. Change this year's income, the losses carried forward, the tax rate and the valuation allowance.

Drawing the numbers…

Try this

Raise this year's income, or lower the losses, until income is bigger than the losses. From that point the company pays cash tax again, and no losses are left.
While the losses cover all of the income, cash tax is zero and the whole book tax expense is the deferred tax asset unwinding.
Raise the share written down. Net income and the net deferred tax asset fall by the same amount, and cash never moves.
Lower the tax rate. The deferred tax asset shrinks, because the same losses now save less tax.

Run it backwards

Same company, reversed: you see the tax expense and the cash tax paid. How much of its losses did it use?

Drawing the numbers…

The whole gap between book tax and cash tax came from losses, and each dollar of loss saves t of tax. So losses used = (book tax − cash tax) ÷ t.

If some cash tax was still paid, the losses ran out this year. If none was paid, the losses covered all of this year's income and some may be left.

Traps

Recording the loss itself as the asset.

The asset is the tax the loss will save: losses × tax rate.

Lowering book tax expense when losses are used.

Book tax is charged on pre-tax income as normal. The losses lower the cash tax, and the deferred tax asset unwinds by the gap.

Treating a valuation allowance as cash.

No payment is made. It is a non-cash increase in tax expense that writes the asset down.

Using more loss than there is income.

Losses used are capped at this year's pre-tax income; the rest carries forward.

Assuming a tax cut is always good news.

A lower rate shrinks a deferred tax asset: a one-off, non-cash hit to net income in the year of the change.

Say it in the interview

The interviewer asks

“What is a deferred tax asset, and how does it work?”

Say yours out loud first, then compare.

Check yourself

4 fresh questions, with new numbers. Answer each one correctly to finish the chapter. Get one wrong and you will see the full working, then you can try it again with new numbers.

Answers within 1% are marked right. Type the number; $, %, x and M are fine. First tries count toward Learned: the topic is Learned once every chapter is done and 75% of first tries were right.

0 of 4

Drawing your questions…

Remember

Deferred tax asset = losses × tax rate.
Book tax on full income; cash tax after using the losses.
The gap is added back in cash flow and unwinds the asset.
Valuation allowance: non-cash, net income down, cash unchanged.