What it means
The problem it solves is that tax rules and accounting rules measure profit differently. Tax authorities may allow faster depreciation, disallow a provision until it is paid, or tax income when cash arrives, so the tax bill in any single year rarely matches the profit in the accounts.
Without allocation, the reported tax charge would jump around for reasons that have nothing to do with performance. A company investing heavily might show a very low tax charge one year and an unexpectedly high one three years later, making the profit after tax line almost useless for comparison.
The mechanism is the matching principle applied to tax. You record the tax on this year's accounting profit, split it between the part payable now, called current tax, and the part deferred to future years, and carry the deferred portion on the balance sheet until it reverses.
Only temporary differences get this treatment. Depreciation timing, provisions and revenue recognition differences all reverse eventually and so create deferred tax, whereas permanent differences such as genuinely non-deductible entertaining never reverse and simply change the effective tax rate.
Two cautions are worth knowing. "Comprehensive" is deliberate, contrasting with partial allocation, which only recognised differences expected to reverse soon, and deferred tax assets are only recognised to the extent future profits are likely enough to use them.
In practice
Real-world examples.
Example
A manufacturer claims accelerated capital allowances on a new production line, cutting its cash tax bill sharply in year one. Comprehensive tax allocation records the full 25% charge in the accounts and parks the difference as a deferred tax liability, so the low cash tax is not mistaken for a permanent saving.
Example
A software company carries forward trading losses from its early years. It recognises a deferred tax asset only once forecasts show reliable taxable profits ahead, and when a major contract is signed the asset is recognised, producing a tax credit in the income statement despite little cash tax movement.
Example
A retailer books a warranty provision that the tax authority will not allow until claims are actually paid. The provision reduces accounting profit now but not taxable profit, so a deferred tax asset arises and unwinds over the following two years as claims are settled.
Formula
Calculation
Total tax expense = current tax payable + the change in deferred tax balances. Deferred tax on a temporary difference = temporary difference x the enacted tax rate.
A company reports pre-tax accounting profit of $4,000,000. Tax depreciation on its equipment exceeds the depreciation charged in the accounts by $800,000 this year, a timing difference that will reverse in later years. The tax rate is 25%.
Taxable profit = $4,000,000 - $800,000 = $3,200,000
Current tax payable = $3,200,000 x 25% = $800,000
Increase in deferred tax liability = $800,000 x 25% = $200,000
Total tax expense = $800,000 + $200,000 = $1,000,000
Effective tax rate = $1,000,000 / $4,000,000 = 25%
Without comprehensive allocation, the income statement would show tax of $800,000, an apparent rate of 20%, overstating profit after tax by $200,000 and implying a tax advantage that is only a deferral.Case study
Seen in the real world.
Aldergate Plastics is an illustrative, fictional injection moulding business whose bank had begun asking why its reported tax rate swung between 12% and 34% from year to year. The answer was capital investment: heavy spending years attracted large tax allowances, and quiet years did not.
In the year it commissioned a $6,000,000 moulding line, tax depreciation was $2,400,000 while the accounts charged straight-line depreciation of $600,000 over ten years, a temporary difference of $1,800,000. At a 25% tax rate that created a deferred tax liability of $450,000. Pre-tax accounting profit was $5,200,000, so taxable profit was $5,200,000 - $1,800,000 = $3,400,000 and current tax was $850,000.
Applying comprehensive allocation, total tax expense became $850,000 + $450,000 = $1,300,000, exactly 25% of the $5,200,000 pre-tax profit. The reported effective rate stopped swinging, the balance sheet showed the deferred liability that would unwind over the line's remaining life, and the bank's credit committee stopped asking the question.
Watch out
Common mistakes.
- Reading a deferred tax liability as a debt owed to the tax authority today. It is an accounting estimate of tax expected in future periods, not an invoice, and it can shrink if circumstances change.
- Recognising deferred tax on permanent differences. Items such as non-deductible fines never reverse, so they change the effective tax rate rather than creating a deferred balance.
- Recognising a deferred tax asset on losses with no realistic prospect of future profits. Assets are only recognised to the extent it is probable there will be taxable profit to use them against.
Questions
People also ask.
Why does my effective tax rate differ from the headline rate?
Permanent differences, overseas rates and adjustments to prior-year estimates all move the effective rate, whereas timing differences alone should leave it close to the statutory rate.
Does comprehensive tax allocation change how much tax the company pays?
No, the cash paid is set entirely by tax law; allocation changes only how the charge is presented and matched across periods.
What is partial allocation?
An older approach that recognised deferred tax only on differences expected to reverse in the near term, now largely replaced by the comprehensive method in mainstream accounting standards.
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