Deferred tax assets and liabilities, year by year
Deferred taxes come from timing: the tax return and the books count some items in different years. A deferred tax liability is tax the company will pay later, most often because it depreciates assets faster for tax. A deferred tax asset is tax it will save later, from expenses booked before they are deductible or from losses carried forward. In our first example, faster tax depreciation creates a $12.5 million liability in year 1 that unwinds to zero by year 3. Soreno, an AI voice interview practice app for consulting, investment banking and other finance candidates, runs a free three-statement model with no sign-up, and mock technical interviews where an AI interviewer asks you to walk deferred taxes through the statements.
Updated
- Timing, not extra tax. Over the asset's life, book tax and cash tax add up to the same total.
- Liability: pay later. Tax deductions taken earlier than the books take them.
- Asset: save later. Expenses booked before they're deductible, or losses carried forward.
- An asset needs a future. If profits to use it are unlikely, a valuation allowance cuts it.
- Twelve questions below. Short answers in our words and the follow-ups to expect.
Deferred taxes in three examples
Every number here is invented by Soreno for practice, in millions of dollars. A 25% tax rate unless a step says otherwise, and no other differences between book and tax income.
Example 1: faster tax depreciation creates a liability$12.5 million, then $12.5 million, then zero
A company buys a $300 million machine. The books depreciate it evenly over 3 years, $100 million a year. For tax it deducts 150, 100, 50, our simplified accelerated schedule. Profit before depreciation is $200 million a year.
Book tax, cash tax and the liability, year by year
| Year | Tax depreciation | Book tax | Cash tax | Deferred | Liability at year end |
|---|---|---|---|---|---|
| 1 | 150 | 25 | 12.5 | 12.5 | 12.5 |
| 2 | 100 | 25 | 25 | 0 | 12.5 |
| 3 | 50 | 25 | 37.5 | −12.5 | 0 |
1. Book tax
$25 million every year
The income statement taxes book profit: (200 − 100) × 25% = $25 million each year.
2. Year 1 cash tax
$12.5 million
The return deducts 150: (200 − 150) × 25% = $12.5 million. The $12.5 million gap is deferred tax expense, and it builds a $12.5 million liability.
3. On the cash flow statement
Add back $12.5 million
Net income reflects $25 million of tax but only $12.5 million left as cash, so the $12.5 million increase in the liability is added back.
4. Year 3 reverses it
Cash tax $37.5 million
Tax depreciation is only 50, so cash tax exceeds book tax by $12.5 million and the liability falls to zero. Over three years, book and cash tax both total $75 million.
Example 2: a loss carried forward, and the 80% limit$25 million asset
A US corporation loses $100 million in year 1, then earns 60 and 80 before any loss deduction in years 2 and 3. The loss arises after 2017. It can't be carried back, and each year's deduction is capped at 80% of that year's taxable income, in the simplified form we use here.
1. The asset
$25 million
$100 million × 25% = $25 million of future tax savings. If profits to use it are more likely than not, the company books it, and its year 1 after-tax loss is $100 million − $25 million = $75 million.
2. Year 2
Uses $48 million, pays $3 million
Income $60 million. The cap is 80% × 60 = $48 million, so taxable income is 60 − 48 = $12 million and tax $3 million. Without the loss it would be $15 million, so it saves $12 million. $52 million of loss is left.
3. Year 3
Uses the last $52 million
Income $80 million, cap $64 million, so all $52 million left is used: taxable $28 million, tax $7 million, a saving of $13 million. Savings total $25 million, the asset booked in year 1.
4. If profits are doubtful
A valuation allowance
If it is more likely than not that the company won't have the profits, it records a valuation allowance against the $25 million. Then year 1 shows no tax benefit and the full $100 million loss.
Example 3: a rate change, and what the asset is worth$2 million gain, $21.65 million of value
Two separate follow-ups. The rate cut in the first doesn't apply to the second, which keeps the 25% rate. First, a law cutting the rate to 21% is enacted at the end of year 1, when example 1's liability stands at $12.5 million. Second, a buyer values example 2's loss, discounting the tax savings at 10%, with savings at each year end.
1. Remeasure
$10.5 million
Deferred taxes are measured at enacted rates. The $50 million difference × 21% = $10.5 million.
2. The effect
$2 million lower tax expense
The liability falls $12.5 million − $10.5 million = $2 million, which goes through income, as lower tax expense, in the period that includes the enactment date. A deferred tax asset would shrink the same way, a charge.
3. What the loss is worth
$21.65 million
Savings of $12 million in year 2 and $13 million in year 3 are worth $12 million ÷ 1.1 + $13 million ÷ 1.1² = $21.65 million today, measured from the end of year 1. The books carry $25 million, undiscounted.
4. In a deal
Check for an ownership change
If a buyer acquires the company, section 382 may limit how much of the old losses can offset its income each year. That can push the savings further out and lower their value again.
From FASB Statement No. 109, Accounting for Income Taxes, now in ASC 740, FASB: summary of Statement No. 109, IFRS Foundation: IAS 12 Income Taxes and IRS: Instructions for Form 1120 (2025).
What the interviewer checks on deferred taxes
In our experience the question is short and the follow-ups test whether you can tell timing from a real saving.
Timing
Say which way the difference runs and when it reverses.
All three statements
Tax expense on the income statement, the change added back or taken off in cash flow, the asset or liability on the balance sheet.
Whether an asset is real
A loss is worth something only with future profits, and only once it's used.
Deals
Write-ups in a stock deal create liabilities. A buyer's use of a target's losses can be limited.
12 deferred tax interview questions
The short answers are ours. The note says what a strong answer adds.
Basics4 questions
What is a deferred tax liability, and where does it come from?
Show follow-ups
Short answer. Tax the company will pay later because it took a deduction earlier for tax than for its books, most often faster tax depreciation.
Gives a number and shows it reversing. Practice it, see a model answer
What creates a deferred tax asset?
Show follow-ups
Short answer. Expenses booked before they are deductible, such as warranty reserves or stock-based compensation, and losses or credits carried forward.
Adds the valuation allowance test. Practice it, see a model answer
What are net operating losses, and how are they used?
Show follow-ups
Short answer. Tax losses carried forward to cut taxable income in profitable years. In the US, post-2017 losses are generally limited to 80% of a year's taxable income.
Works one year through. Practice it, see a model answer
What is a valuation allowance?
Show follow-ups
Short answer. A reduction of a deferred tax asset when it is more likely than not that some of it won't be realized, usually because future profits are in doubt.
Says what releasing one does to earnings.
On the statements4 questions
Depreciation goes up by $10. Walk me through the three statements.
Show follow-ups
Short answer. Pre-tax income falls $10 and net income by the after-tax amount. Cash rises by the tax saved, PP&E falls $10 and equity falls by the net income drop.
Says whether the change is book only or also tax, and what that means for deferred taxes. Practice it, see a model answer
How do the three financial statements link together?
Show follow-ups
Short answer. Net income starts the cash flow statement and flows into retained earnings. Cash flow ends in the balance sheet's cash.
Uses the deferred tax change as one of the links. Practice it, see a model answer
A company records $10 of stock-based compensation. Walk me through the three statements.
Show follow-ups
Short answer. Expense $10, net income down after tax, $10 added back in cash flow, paid-in capital up. If the deduction comes later, a deferred tax asset appears.
States the tax assumption first. Practice it, see a model answer
Why does a rate change move deferred taxes?
Show follow-ups
Short answer. They are measured at enacted rates, so a new rate remeasures them, and the effect goes through income in the period that includes the enactment date.
Says which way a rate cut moves a liability and an asset.
Deals and valuation4 questions
What's the difference between an asset deal, a stock deal and a 338(h)(10) election?
Show follow-ups
Short answer. In an asset deal the tax basis steps up. In a stock deal it doesn't, so book write-ups create a deferred tax liability. A 338(h)(10) election treats a stock deal as an asset sale for tax.
Links the liability to goodwill. Practice it, see a model answer
How would you value a company's NOLs?
Show follow-ups
Short answer. Project when they can be used, apply the tax rate and any annual limit, and discount the savings. That is usually below the book asset.
Works example 3's numbers.
When does a company capitalize a cost instead of expensing it?
Show follow-ups
Short answer. When it brings benefits beyond the current year, such as equipment. Book and tax rules can differ on this, which creates temporary differences.
Names one cost treated differently for book and tax. Practice it, see a model answer
How can a company be profitable and still run out of cash?
Show follow-ups
Short answer. Working capital, capex and debt repayment use cash that profit doesn't show. Taxes can too, when cash tax runs above book tax as a liability unwinds.
Uses example 1's year 3. Practice it, see a model answer
More to prepare with
Common deferred tax mistakes
Calling it a permanent saving
In example 1 book and cash tax both total $75 million. Only the timing changes.
Getting the direction wrong
Bigger deductions now on the tax return mean a liability, not an asset.
Using a loss in full in one year
The 80% cap leaves $52 million for year 3 in example 2.
Valuing an NOL at book value
The book asset is $25 million. Discounted, it is worth $21.65 million.
Anticipating a rate change
Deferred taxes move only when a new rate is enacted, not when one is proposed.
Walk the tax line out loud
Soreno's AI interviewer asks where a deferred tax liability comes from, then gives you a loss and asks what it's worth. You get a scored report on your answer.
Questions people ask
What is the US GAAP approach to income taxes?
FASB's summary of Statement No. 109 calls it an asset and liability approach: a current tax liability or asset for this year's return, and deferred tax liabilities and assets for the future tax effects of temporary differences and carryforwards, measured under enacted law without anticipating future changes in rates.
When is a valuation allowance needed?
Under Statement No. 109, when, based on the weight of available evidence, it is more likely than not that some or all of a deferred tax asset will not be realized.
How does IFRS handle deferred taxes?
The IFRS Foundation's summary says IAS 12 requires a deferred tax liability, or subject to conditions an asset, for all temporary differences with some exceptions. Temporary differences are differences between an item's tax base and its carrying amount on the balance sheet.
Can US companies carry losses back?
The IRS's 2025 instructions for Form 1120 say only farming losses and losses of certain insurance companies can be carried back, for 2 years. Other losses are carried forward.
What is the 80% limit on NOLs?
For 2025, the IRS instructions cap the deduction for losses from tax years beginning after December 31, 2017, at 80% of taxable income figured without the NOL and certain other deductions, plus any older losses, which aren't capped this way.
Do deferred taxes count as debt in enterprise value?
Usually not. In our experience bankers leave deferred tax liabilities out of the enterprise value bridge, but may value large NOLs separately.