What creates a deferred tax asset?

Name the two sources: tax losses carried forward and costs expensed before they're deductible, like a warranty reserve. At a 25% rate, $100 of losses is a $25 asset. Mention the valuation allowance and that a rise reduces operating cash flow.

The numbers, step by step

The two examples from the answer, each at a 25% tax rate.

Asset from $100 of losses carried forward$100 × 25%

$25

Asset from a $40 warranty reserve$40 × 25%

$10

What the interviewer listens for

• Do you name net operating losses as a main source?
• Can you give a cost that's expensed before it's deductible, with numbers?
• Do you get the direction right: more cash tax now, less later?
• Do you mention the valuation allowance?
• Do you subtract an increase on the cash flow statement?

Common mistakes

• Describing a deferred tax liability by mistake.An asset comes from paying more cash tax than tax expense, or from losses carried forward.
• Treating it like cash.It's only worth something if the company earns taxable income to use it.
• Forgetting the valuation allowance when the company is unlikely to ever use the asset.
• Adding back an increase on the cash flow statement.A rising deferred tax asset reduces operating cash flow.

Likely follow-ups

• What happens when the warranty claims are paid?The company gets its $40 deduction, cash tax falls $10 below tax expense that year, and the deferred tax asset goes back to zero.
• What does releasing a valuation allowance do to earnings?Tax expense falls and net income jumps, but no cash moves, so I'd treat it as a one-time item.
• How would you value a deferred tax asset from losses in a deal?At the present value of the tax it will actually save, after checking when the losses can be used and any limit after an ownership change, like Section 382 in the US.

More finance technicals

• How do you account for a 30% stake in another company?
• How do the three financial statements link together?
• Depreciation goes up by $10. Walk me through the three statements.
• A company raises $100 of debt to buy equipment. Walk me through the three statements at the time of purchase.
• What is working capital, and why does it matter for cash flow?

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