What it means
Accrual accounting matches costs with the revenue they help to generate. When a cost is paid in advance of the periods it relates to, charging it all at once would depress the period of payment and flatter the later periods that actually receive the benefit.
The solution is to defer it: to record the payment as an asset and to expense it over the periods it serves. The asset is not a physical thing the company could sell; it is a right to future benefit that the company has already paid for, and its value lies in the expense the company will not have to pay again.
The simplest deferred assets are prepaid expenses: rent, insurance, subscriptions and maintenance contracts paid ahead of the period covered, held as current assets and expensed month by month. Deferred charges are longer-term and more varied.
The costs of obtaining a customer contract, such as sales commissions, are capitalised under current revenue recognition standards if the company expects to recover them, and amortised over the contract's life. The costs of fulfilling a contract before delivery begins, such as set-up and mobilisation, are similarly deferred.
Costs of arranging a loan were historically shown as a deferred asset and are now deducted from the loan liability, but the effect, spreading them over the loan's life, is the same. Some tax systems and older accounting frameworks allowed start-up and pre-opening costs to be deferred; modern standards generally require them to be expensed.
Deferred tax assets are the most significant and the most technical category. They arise when a company has paid, or will pay, more tax in the current period than its accounting profit implies, with the difference reversing in future: a tax loss that can be carried forward against future profits, an expense recognised in the accounts now but deductible for tax only when paid (such as a provision or accrued bonus), or an asset whose tax base exceeds its book value.
The asset represents the tax the company will save in future because of what has already happened. It is recognised only to the extent that future taxable profits are probable, because a tax loss is worth nothing to a company that never makes a profit to set it against, and the assessment of recoverability is one of the most judgemental areas in the accounts.
The distinction between a deferred asset and an ordinary expense is one of future benefit, and it invites abuse. A company under pressure to report profit can be tempted to describe current costs as investments in the future and defer them: research, marketing, training, restructuring, pre-opening costs, software development that does not meet the criteria.
Each deferral moves cost out of the current income statement and on to the balance sheet, from which it must eventually be expensed or written off. Accounting standards have progressively tightened the criteria, and auditors pay particular attention to deferred assets that grow faster than the business, because they are a classic sign of profit being manufactured rather than earned.
Readers of financial statements should therefore check what deferred assets a company carries, how large they are relative to equity, how they are being amortised, and whether the future benefit is credible. A deferred tax asset that has been carried for years by a company that keeps making losses, capitalised contract costs that are growing while contract revenue is not, or deferred charges of a kind that standards do not permit are all warnings.
The question to ask is the one that defines the category: is there a genuine future benefit for which this cost has already been paid?
In practice
Real-world examples.
Example
A telecommunications company capitalises the $120 cost of connecting each new customer and amortises it over the customer's expected two-year relationship, as a cost of fulfilling the contract.
Example
A manufacturer recognises a deferred tax asset of $175,000 on a $700,000 warranty provision, because the provision is an expense in the accounts now but will be deductible for tax only when claims are paid.
Example
A retailer that deferred store pre-opening costs is required by its auditors to expense them, since the applicable standard does not treat them as an asset.
Think of it
“A deferred asset is something you paid for that will benefit you later-an expense waiting to happen.
Formula
Calculation
Deferred asset at period end = Cost deferred minus Amortisation to date
Amortisation per period = Cost deferred / Number of periods benefiting
Deferred tax asset = Deductible temporary differences (or Tax losses carried forward) x Applicable tax rate, limited to the amount probable of recovery
Worked example: capitalised contract costs. A software company pays a sales commission of $240,000 on signing a three-year customer contract. The commission is an incremental cost of obtaining the contract and is expected to be recovered from the contract's margin.
- At signing: debit deferred contract costs $240,000; credit cash $240,000
- Amortisation = $240,000 / 3 = $80,000 a year, matched to the contract revenue
- Balance sheet after year 1: deferred contract costs $160,000; after year 2: $80,000; after year 3: nil
- Without deferral, the first year would carry the whole $240,000 against one year's revenue and the other two years would carry none
Worked example: deferred tax asset on losses. A company makes a tax loss of $2,000,000 which can be carried forward indefinitely against future profits. The tax rate is 25%.
- Potential deferred tax asset = $2,000,000 x 25% = $500,000
- The board's approved forecasts show taxable profits of $1,200,000 over the next three years, beyond which the forecasts are not considered reliable enough to support recognition
- Recognised deferred tax asset = $1,200,000 x 25% = $300,000; the remaining $200,000 is unrecognised and disclosed
- If profits exceed the forecast, the unrecognised portion is recognised later, reducing the tax charge in that period
Worked example: deferred financing costs. A company pays $300,000 of arrangement fees on a five-year loan. The fees are deducted from the loan liability and released through the effective interest rate: about $60,000 a year of additional interest expense, so that the total cost of the loan, coupon plus fees, is spread over the years the loan is in use.Case study
Seen in the real world.
A restaurant chain opening fifteen new sites in a year incurred about $300,000 of pre-opening costs per site: staff recruitment and training, rent during the fit-out, marketing for the launch, and food used in trial service. The finance director capitalised these costs as a deferred asset, on the argument that they created the future benefit of a trading restaurant, and amortised them over five years. The accounts for the year showed $4,500,000 of costs deferred, $900,000 amortised, and a profit of $6,000,000 that the board presented to its bank as evidence of a successful expansion.
The auditors did not accept the treatment. The applicable accounting standard was explicit that pre-opening and start-up costs must be expensed as incurred, because they do not create a separately identifiable asset: the training walks out of the door with the staff, the launch marketing has been consumed, and the future benefit belongs to the restaurant's ordinary trading, not to the costs of getting it open. Restating the accounts to expense the costs, net of the amortisation already charged, reduced the year's profit by $3,300,000 to $2,700,000, and the deferred asset disappeared from the balance sheet, reducing equity by the same amount.
The consequences went beyond the numbers. The chain's loan agreement had a leverage covenant based on earnings, and on the restated figures it was breached; the bank granted a waiver, at a fee and with a tighter margin, and the board's credibility with its lender was damaged. The finance director's successor introduced a policy that any proposal to defer a cost would be tested against the standard's criteria and documented before the entry was made, and that the board would be shown profit both before and after any deferrals so that it could see the effect.
The chain's expansion was in fact a success; the sites traded well and the chain grew. What the deferral had done was to bring forward profit that the sites would earn in due course, and to present to the bank a picture that the accounting rules were specifically designed to prevent.
Watch out
Common mistakes.
- Deferring costs because they are described as investments in the future, when the standard requires them to be expensed; training, marketing, research and pre-opening costs are the usual candidates.
- Recognising a deferred tax asset on losses without a credible forecast of the taxable profits needed to use it, so that the asset overstates equity and is eventually written off.
- Failing to amortise deferred charges, or amortising them over a period longer than the benefit, so that the balance sheet carries costs whose benefit has already expired.
Questions
People also ask.
What is the difference between a deferred asset and a fixed asset?
A fixed asset is a physical or intangible thing the company controls and uses; a deferred asset is a cost paid in advance of the benefit it provides, with no separate existence of its own. Both are expensed over time, but a fixed asset can usually be sold and a deferred asset cannot.
What is a deferred tax asset?
The future tax reduction the company expects because of something that has already happened: a tax loss carried forward, or an expense recognised in the accounts before it is deductible for tax. It is recognised only to the extent that future taxable profits are probable.
Why do auditors scrutinise deferred assets?
Because deferring a cost moves it out of the income statement and on to the balance sheet, raising reported profit. Companies under pressure sometimes defer costs that should be expensed, and deferred assets that grow faster than the business are a classic warning sign.
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