What it means
Accounting profit and taxable profit are calculated by different rules for different purposes. The accounts aim to show the economic performance of the period, whereas the tax computation follows the law, which allows some deductions faster (accelerated depreciation to encourage investment), some slower (provisions deductible only when paid) and some never (entertaining, fines).
If the tax charge in the income statement were simply the tax payable for the year, the reported tax rate would swing for reasons unrelated to performance, so deferred tax recognises, in the year a difference arises, the tax that will be paid or saved when it reverses. The mechanism is the balance sheet liability method.
For every asset and liability, the company compares its carrying amount in the accounts with its tax base, the amount that will be deductible or taxable in future, and the difference is a temporary difference. A taxable temporary difference, where the carrying amount of an asset exceeds its tax base, gives rise to a deferred tax liability, while a deductible temporary difference, where the tax base exceeds the carrying amount or a liability will be deductible when settled, gives a deferred tax asset.
Each difference is multiplied by the tax rate expected to apply when it reverses, and the movement in the total from one year to the next is the deferred tax charge or credit in the income statement. The commonest source of deferred tax liabilities is plant and equipment on which tax depreciation runs ahead of book depreciation, with others being revalued assets, intangible assets recognised in acquisitions and profits of overseas subsidiaries that will be taxed when distributed.
Deferred tax assets arise from provisions and accruals deductible only when paid, tax losses carried forward, share-based payments and retirement benefit obligations. A deferred tax asset is recognised only to the extent that it is probable that future taxable profits will be available to use it, which requires a judgement about the company's prospects and is a frequent subject of audit attention and, in loss-making companies, of write-offs.
The total tax charge is the current tax payable for the year plus the deferred tax movement, and the effective tax rate, total tax divided by accounting profit, should be close to the statutory rate adjusted for permanent differences, with a reconciliation in the notes explaining any gap. Deferred tax also responds to rate changes, because when a government enacts a new rate every temporary difference is remeasured at the rate expected to apply on reversal, and the resulting one-off charge or credit has no cash consequence.
For a business, the practical significance of deferred tax lies in cash planning and in the assessment of value. A deferred tax liability is a genuine future cash outflow, deferred rather than avoided, and a company that stops investing or sells revalued assets will find its cash tax rising as the liability unwinds.
A deferred tax asset is a genuine future saving only if the company earns the profits to use it, so its recognition is a statement of confidence in those profits. Analysts treat deferred tax liabilities as a soft, interest-free form of debt and deferred tax assets as a contingent benefit, and adjust their valuations accordingly.
Managers should read the deferred tax lines in the same spirit as other future cash flows.
In practice
Real-world examples
Example 1
A haulage company that claims accelerated tax depreciation on its trucks carries a deferred tax liability of $1,200,000, which grows while the fleet is expanding and shrinks when it stops.
Example 2
A start-up with $3,000,000 of accumulated tax losses recognises a deferred tax asset of $750,000 in the year its board first approves a forecast showing sustained taxable profits.
Example 3
A property investor revalues its buildings upwards by $10,000,000 and records a deferred tax liability of $2,500,000 through other comprehensive income, alongside the revaluation gain.
Think of it
Deferred taxes are like buying something on layaway. The tax effect is spread over time-you're either prepaying future taxes or deferring current ones.
Formula
Calculation
Temporary difference = Carrying amount in the accounts minus Tax base
Deferred tax liability = Taxable temporary differences x Tax rate expected on reversal
Deferred tax asset = Deductible temporary differences (including unused tax losses) x Tax rate, limited to the amount probable of recovery
Deferred tax charge (credit) for the year = Closing net deferred tax liability minus Opening net deferred tax liability
Total tax charge = Current tax + Deferred tax charge
Effective tax rate = Total tax charge / Accounting profit before tax
Worked example. A company with a 25% tax rate has the following positions at its year end.
- Plant and equipment: carrying amount $700,000; tax written-down value $421,875; taxable temporary difference $278,125; deferred tax liability = $278,125 x 25% = $69,531
- Warranty provision: carrying amount $200,000; tax base nil (deductible when claims are paid); deductible temporary difference $200,000; deferred tax asset = $50,000
- Unused tax losses of $400,000, expected to be used against next year's profits; deferred tax asset = $100,000
- Net position: deferred tax assets $150,000 minus deferred tax liability $69,531 = net deferred tax asset of $80,469
Income statement. Accounting profit before tax is $2,000,000. Current tax payable for the year is $380,000. The net deferred tax asset was $200,469 at the start of the year and is $80,469 at the end, so the deferred tax charge is $120,000 (the asset has reduced, meaning tax deferred earlier is now falling due).
- Total tax charge = $380,000 + $120,000 = $500,000
- Effective tax rate = $500,000 / $2,000,000 = 25%, equal to the statutory rate; without deferred tax, the reported rate would have been 19%, which would have misrepresented the company's tax cost
Rate change. If the government enacts a rate of 28% for future years, the plant and equipment liability is remeasured at $278,125 x 28% = $77,875, an increase of $8,344 charged to the income statement, and the assets are remeasured likewise; no cash moves.Case study
Seen in the real world
This is a fictional, illustrative scenario. A packaging manufacturer spent five years expanding its plant, investing about $6,000,000 a year in machinery on which the tax rules allowed a first-year deduction far larger than the straight-line depreciation in its accounts. Its accounting profit was a steady $8,000,000 a year and its total tax charge at the 25% rate was $2,000,000, but the split told the story of the investment: current tax of about $1,400,000 a year and a deferred tax charge of about $600,000, with the deferred tax liability growing to $3,000,000 by the end of the fifth year. Its cash tax rate was 17.5% of accounting profit, and the finance director's board reports made much of the "tax efficiency" of the programme.
The expansion complete, the company stopped investing and the liability began to unwind. The accounts still showed a total tax charge of $2,000,000 on profit of $8,000,000, but the composition reversed: current tax rose to about $2,600,000 a year while the deferred tax line became a credit of about $600,000, as the accelerated deductions ran out. Cash tax was $1,200,000 a year higher than during the investment years, and the cash flow forecast, built on the investment-era tax rate, showed a shortfall. The board, which had understood the deferred tax liability as a technicality, now understood it as a bill that had been building for five years.
The finance director's revised forecast treated the $3,000,000 balance as a schedule of future tax payments over the following five years and adjusted the distribution policy to match. The lesson recorded for the board was that the deferred tax charge had been showing the true cost of tax all along: the "tax efficiency" had been a deferral, worth the interest on the postponed payments and no more. Cash planning thereafter distinguished between tax saved and tax postponed.
Watch out
Common mistakes
- Treating deferred tax liabilities as tax that will never be paid; each temporary difference reverses, and a company that stops investing or sells the related asset pays the tax in cash.
- Recognising a deferred tax asset on losses without a credible forecast of the profits needed to use it, which overstates assets and equity until the asset is written off.
- Using the current tax rate for all temporary differences when a different rate has been enacted for the periods in which they will reverse.
Questions
People also ask
What is the difference between current tax and deferred tax?
Current tax is the tax payable on the taxable profit of the year. Deferred tax is the future tax effect of differences between accounting and taxable profit that will reverse in later years. The total tax charge in the income statement is the sum of the two.
Why does deferred tax matter if it is not cash?
Because it shows the true long-term cost of tax on the profit reported, keeps the effective tax rate meaningful, and warns of future cash tax payments (liabilities) or savings (assets). The cash follows when the differences reverse.
What is a permanent difference?
An item that affects accounting profit but never affects taxable profit, or the reverse, such as entertaining expenses that are never deductible or income that is exempt from tax. Permanent differences do not create deferred tax; they change the effective tax rate.