What it means
Accounting profit and taxable profit are calculated under different rulebooks, so they rarely match. Some of the gaps are permanent, such as a fine that is never deductible, but many are simply about timing, where the same amount is counted in both systems in different years.
Deferred tax exists to capture those timing gaps. If a business claims faster depreciation for tax than it charges in its accounts, it pays less tax now and more later, and deferred tax records that future obligation instead of letting it appear as a surprise.
The most common source is exactly that depreciation difference. Others include provisions that are recognised in the accounts before they are deductible, tax losses carried forward, and revenue recognised in different periods for accounting and tax purposes.
The practical importance for managers is that the tax line in the income statement is not the cash tax bill. Total tax expense is current tax plus the movement in deferred tax, which is why a company can report a 25% effective tax rate while paying a very different amount to the tax authority that year.
One important nuance is recoverability. A deferred tax asset can only be recognised if the business expects enough future taxable profit to use it, so loss-making companies often carry unrecognised tax losses and then book a large deferred tax asset in the year they return to profit.
In practice
Real-world examples.
Example
A logistics group invests heavily in new trucks and claims accelerated tax depreciation. Its deferred tax liability grows from $400,000 to $1,100,000 in a year, signalling to analysts that its low current cash tax bill is borrowed from future years.
Example
A biotechnology company accumulates $6,000,000 of tax losses while pre-revenue and recognises no deferred tax asset because profits are uncertain. When its first product launches and profitability becomes likely, it books a $1,500,000 deferred tax asset at a 25% rate, which flatters that year's reported profit.
Example
A retailer records an $800,000 provision for store closure costs that is not tax deductible until the cash is spent. It recognises a $200,000 deferred tax asset at 25%, which unwinds as the closure costs are actually paid over the following two years.
Formula
Calculation
Deferred tax = temporary difference x expected tax rate. Total tax expense = current tax payable + increase in deferred tax liability.
A company buys machinery for $500,000 and depreciates it in the accounts over five years on a straight line basis, giving $100,000 of book depreciation in year one. The tax rules allow accelerated depreciation of $200,000 in year one. Profit before depreciation is $800,000 and the tax rate is 25%.
Accounting profit = $800,000 - $100,000 = $700,000, so tax expense at 25% = $175,000
Taxable profit = $800,000 - $200,000 = $600,000, so current tax payable = $150,000
Temporary difference = $200,000 - $100,000 = $100,000
Deferred tax liability = $100,000 x 0.25 = $25,000
The income statement shows a total tax charge of $175,000, made up of $150,000 payable now and $25,000 deferred. Check: $150,000 + $25,000 = $175,000. In later years the position reverses, because tax depreciation runs out first and the company then pays more tax than its accounting profit implies, drawing the $25,000 liability back down to zero.Case study
Seen in the real world.
Winslow Precision is an illustrative, fictional engineering firm used to show how deferred tax confuses non-specialists. Its managing director spent three board meetings arguing that the accountants had made an error, because the accounts showed a $175,000 tax charge while the company had only transferred $150,000 to the tax authority.
The finance director explained the $25,000 gap using the machinery bought that year. Winslow had claimed $200,000 of tax depreciation against $100,000 of book depreciation, and the resulting $100,000 temporary difference at a 25% rate created a $25,000 deferred tax liability, which is a real future obligation rather than an accounting invention.
Once the point landed, the board started asking a better question. It wanted to know when the liability would reverse, because the answer told them their cash tax bill would rise noticeably in years three to five even if profits stayed flat, and in this fictional example that single insight changed how they planned dividends.
Watch out
Common mistakes.
- Reading deferred tax as money owed to the tax authority right now. It is an accounting measure of future tax consequences, and no payment is due on the balance sheet date.
- Assuming the tax charge in the income statement equals the cash paid. Total tax expense combines current tax with the movement in deferred tax, and the two can differ substantially in any given year.
- Recognising deferred tax assets on losses without evidence of future profits. Accounting standards require it to be probable that the losses will actually be used, and optimistic recognition is a common audit challenge.
Questions
People also ask.
What is the difference between a temporary and a permanent difference?
Temporary differences reverse over time and create deferred tax, while permanent differences such as non-deductible fines never reverse and simply change the effective tax rate.
Why did our deferred tax balance change when the tax rate changed?
Deferred balances are measured at the rate expected when the difference reverses, so a rate change remeasures the whole balance and creates a one-off gain or charge.
Does deferred tax affect cash flow?
Not directly, which is why it is added back as a non-cash item when reconciling profit to operating cash flow.
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