Case 20 / 183 Analyst
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Deferred Taxes

Accounting & Financial Statements

The prompt

“Walk me through how deferred tax assets and deferred tax liabilities arise, and tell me which one you'd record when a company recognizes an expense for book purposes before it's deductible for tax purposes.”

📋 What you're given

Walk me through how deferred tax assets and deferred tax liabilities arise, and tell me which one you'd record when a company recognizes an expense for book purposes before it's deductible for tax purposes.

1. Task Overview

Task: identify whether each timing difference below creates a deferred tax asset (DTA) or a deferred tax liability (DTL), and compute the resulting balance for each and the net deferred tax position.

Step 1: Given Data — Book vs. Tax Treatment

A company reports the following two items differently for book (GAAP) purposes than for tax purposes in the current year.

Line ItemBook TreatmentTax Treatment
Depreciation Expense (Year 1)$150.0m (straight-line)$250.0m (accelerated)
Warranty Expense Accrued$40.0m (estimated, expensed immediately)$0.0m (deductible only when claims are paid)
Line ItemValue
Statutory Tax Rate25% (0.25)

Step 2: The Depreciation Timing Difference

Compare what the company deducts on its tax return this year to what it expenses on its books, and think about which direction that timing difference points.

Show Depreciation Timing Difference Formula

If Tax Depreciation > Book Depreciation, the difference × Tax Rate creates a Deferred Tax Liability (DTL) — the company pays less cash tax now and more later.

Using this, determine whether the depreciation timing difference creates a DTA or DTL, and compute its amount.

Step 3: The Warranty Timing Difference

Compare when the warranty expense hits the books to when it's actually deductible for tax, and think about which direction that timing difference points.

Show Warranty Timing Difference Formula

If Book Expense > Tax-Deductible Expense, the difference × Tax Rate creates a Deferred Tax Asset (DTA) — the company pays more cash tax now and less later.

Using this, determine whether the warranty timing difference creates a DTA or DTL, and compute its amount.

Step 4: Net Deferred Tax Position

Show Net Deferred Tax Formula

Net Deferred Tax Position = DTL − DTA

Assume:

  • Both temporary differences relate to the same tax jurisdiction and are eligible to be netted
  • Tax rate = 25% (0.25), expected to stay constant
  • No valuation allowance is needed against the DTA (future taxable income is expected to be sufficient)

Using these inputs, compute the company's net deferred tax position and state whether it is a net asset or a net liability.

💡 Model answer

Try answering out loud first — then reveal the model answer and compare.

⚠️ Common mistakes

  • Mixing up the direction: deducting more for tax now than for book (like accelerated depreciation) creates a liability (you'll owe more tax later), while expensing more for book now than is tax-deductible (like the warranty accrual) creates an asset (you've pre-paid tax, in effect)
  • Recording the gross timing difference instead of multiplying by the tax rate — deferred tax balances are always the temporary difference times the tax rate, not the raw dollar difference itself
  • Treating deferred taxes as permanent differences — DTAs and DTLs exist because the difference reverses in a future period; permanent differences (like non-deductible fines or non-deductible goodwill impairment) never create a deferred tax balance
  • Forgetting to consider a valuation allowance against a DTA when future taxable income is uncertain
  • Assuming the tax rate used is always the current one — deferred tax balances should be measured at the rate expected to apply when the difference reverses

🔁 Follow-up questions

← Previous Case 19: IFRS 16: Lease Accounting Next Case 21: Free Cash Flow from the Statements →

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