The Daily Technical #117: How does buying a building impact the three financial statements?

Good morning. Welcome to the 117th edition of The Daily Technical. You’re here for one reason so let’s dive in.

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OVERVIEW OF YESTERDAY’S QUESTION
What are deferred tax assets (DTAs)?

Deferred tax assets ("DTAs") are created when a company recognizes a tax expense on its GAAP income statement that, due to a temporary timing difference between GAAP and IRS accounting rules, is lower than what must be paid to the IRS for that period.

These net operating losses ("NOLs") that a company can carry forward against future income create DTAs.

For example, a company that reported a pre-tax loss of $10 million will not get an immediate tax refund.

Instead, it'll carry forward these losses and apply them against future profits.

However, under GAAP, the tax benefit will be recognized from a presumed future tax refund immediately on the income statement, and this difference gets captured in DTAs.

As the company generates future profits and uses those NOLs to reduce future tax liabilities, the DTAs gradually reverse.

Another reason for DTAs is the differences between book and tax rules for revenue recognition.

Broadly, tax rules require recognition based on receiving cash, while GAAP adheres rigidly to accrual concepts.

Common Mistakes

1. Ignoring how timing differences between GAAP and IRS rules create DTAs. Always analyze how temporary differences in revenue or expense recognition affect tax calculations, leading to the formation or reversal of these assets.

2. Forgetting that DTAs will reverse as future profits reduce tax liabilities. Be sure to consider how and when these profits will allow the company to utilize its NOLs, resulting in a gradual reversal of the DTA on the balance sheet.

3. Misinterpreting how revenue recognition gaps between GAAP and IRS rules affect DTAs. Recognize that while tax rules focus on cash received, GAAP follows accrual principles, influencing when and how DTAs are recorded.

TL;DR

• Deferred tax assets arise from temporary timing differences between GAAP and IRS rules.

• Created when GAAP tax expense is lower than IRS tax payment, often due to net operating losses (NOLs).

• NOLs carried forward to offset future income; creates DTAs on the balance sheet.

• DTAs recognized immediately on GAAP statements, reverse as future profits utilize NOLs.

• Differences in revenue recognition (cash vs. accrual) can also generate DTAs.

TODAY’S QUESTION
How does buying a building impact the three financial statements?

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THAT’S A WRAP
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