Deferred Tax Assets and Liabilities

Accounting rules and tax rules often disagree on when an expense or piece of income counts. A company might depreciate a machine slowly on its shareholder books but quickly on its tax return, because tax law allows faster write-offs. In the early years this means the company pays less cash tax than the expense on its income statement would suggest — the difference is recorded as a deferred tax liability, a future tax bill that will come due once the tax-book depreciation catches up. Run the timing the other way — say a company books an expense for shareholders today (like a warranty reserve) that the tax authority won't let it deduct until cash is actually paid out later — and it's paying more cash tax now than its reported expense implies, creating a deferred tax asset: a future tax saving it hasn't cashed in yet.

Deferred tax assets also arise from accumulated losses (net operating loss carryforwards) that can offset future taxable income, provided the company expects to be profitable enough to actually use them — if not, accountants must record a "valuation allowance" writing the asset down, which is itself a signal worth watching.

Consider a company with $100 of pre-tax book income but only $60 of taxable income this year because of accelerated tax depreciation, at a 25% tax rate. Book tax expense is $25\% \times 100 = 25$, but cash tax paid is $25\% \times 60 = 15$. The $10 difference is added to deferred tax liabilities — a bill that will eventually come due as the depreciation timing difference reverses.