Introduction to Prepaid Assets and Liabilities
Because of the timing differences with taxes, a company will often estimate the potential tax liability and make payments over the course of the year, generally quarterly. Sometimes, a business will overestimate the taxes and overpay, resulting in a prepaid tax. Prepaid taxes are only slightly different from deferred tax assets; prepaid taxes will reverse within one year, whereas a deferred tax asset may take over one year to reverse. Prepaid taxes are not the only way that prepaid assets and prepaid liabilities can occur. Insurance is one of the most common prepaid assets, since by its nature insurance pays in advance of later occurrences.
Potentially more complex are prepaid liabilities. For instance, if Industry Corp. sells television sets, it may want payment before shipping products. From the time that the money is collected, but before the televisions are delivered, there is a liability. At first glance, it may seem that this amount should be revenue, but an accountant would see this as a liability because it needs to be paid out of inventory. The liability is unearned income. One benefit of deferred tax assets is that they will lower the net income of Industry Corp. The amount that is paid will be an expense on its income statement. This gives a lower tax base and a smaller tax liability.
A deferred tax asset is often the by-product of poor estimations; it is important to address these, or they will continue to occur. Their result is a rolling asset that is always on the company's records, canceling out the benefits associated with having the asset.
Effect of Deferred Tax Assets on Financial Statements
A deferred tax asset is a current asset owned and created when more tax is paid in advance. Both deferred tax liabilities and deferred tax assets are reported on the balance sheet.
Deferred tax assets and deferred tax liabilities have a substantial enough impact on the financial health of the company that the varying tax regulations and their implications must be navigated carefully. Tax arbitrage is the practice of managing the tax implications, or the process of using differences in tax codes to make a profit. There are a variety of ways companies and investors benefit from the tax implications of wise business decisions. The parent company may move activities to subsidiary companies in locations with more favorable tax rules. For example, interest paid on loans would be tax-deductible in some countries, lowering the taxable income. A multinational company may create a tax asset in a country with a low tax rate, using the tax liability created in a high-tax country. This will result in a net increase in financial statement income and assets. A company may choose to use tax-exempt bonds as a short-term cash management strategy because the interest paid on these bonds (e.g., municipal bonds) is not taxed by the federal government and, in many cases, state governments. However, the line between tax arbitrage and tax evasion, using illegal methods to deliberately avoid paying taxes, is thin. Tax arbitrage should be conducted with care.