A deferred tax asset arises when tax payable (based on taxable income) is higher than the equivalent amount payable based on accounting profit. It is recognized because a company expects future taxable income to be lower than accounting profit. However, a valuation allowance, a contra-account to a deferred tax asset, is created to the extent a company is not sure if it will be able to utilize the deferred tax asset. A deferred tax liability results when tax payable is lower than its equivalent figure based on accounting profit.
A deferred tax asset or liability most often arises when tax laws and accounting standards recognize transactions in different periods. Such differences are called temporary differences because they are expected to eventually reverse or self-correct.
For example, tax laws might require a customized accelerated depreciation method, but the accounting standards might dictate that the straight-line method is most appropriate. This would result in deduction of a greater depreciation expense in the calculation of taxable income resulting in lower current income tax. However, since total depreciation over the life of the asset is equal, the difference would eventually reverse such that in some future period, lower depreciation expense would be allowed under tax laws.
Deferred tax asset just transfers the tax benefit enjoyed today to a future period in which the associated revenue or expense item is recognized. Any change in deferred tax assets and liabilities is added to the current income tax payable to determine the company’s total income tax expense (credit).
At the end of each year, a company reassesses the likelihood of realization of deferred tax assets and liabilities; and reverses the deferred tax asset or liability if it follows IFRS or recognizes appropriate valuation allowance (a contra-account), if it follows US GAAP.