What it means
Financial accounting aims to show a fair picture of performance to shareholders and lenders, while tax accounting aims to compute a figure the tax authority will accept. The two start from the same transactions but apply different rules on depreciation, provisions, entertaining, and when income is recognised.
Because of that, a company runs two parallel calculations. The accounts show a profit before tax under accounting standards, and the tax computation adjusts that figure for disallowed costs, different depreciation and timing differences to arrive at taxable profit.
Tax accounting matters because the tax line is often the largest single deduction between profit before tax and profit after tax, and because getting it wrong creates both a misstated result and a compliance problem. Analysts also read the tax note closely, since an unusual effective rate can signal one-off items or aggressive positions.
The central technical idea is deferred tax. Where the accounting and tax treatments of the same item differ only in timing, the accounts recognise a deferred tax liability or asset so that the tax expense reported matches the profit reported, even though the cash payment falls in a different year.
Permanent differences work differently. Costs that are never deductible, such as certain fines and entertaining, create no deferred tax at all; they simply push the effective tax rate above the headline rate for good.
In practice
Real-world examples.
Example
A distribution company claims 100% first-year allowances on $800,000 of new vehicles while depreciating them over five years in the accounts. Its cash tax bill falls sharply this year, but a deferred tax liability of $200,000 at a 25% rate appears on the balance sheet to reflect the tax that will be paid later.
Example
A loss-making biotechnology firm has $3,000,000 of tax losses carried forward. It recognises a deferred tax asset only for the portion it can realistically use within its forecast horizon, because recognising the whole amount would assume profits it cannot yet demonstrate.
Example
A retailer books a $250,000 provision for a store closure. The provision reduces accounting profit immediately but is not deductible for tax until the costs are actually paid, so the tax computation adds it back and a deferred tax asset is recognised.
Formula
Calculation
Total tax expense = Current tax on taxable profit + Movement in deferred tax
Fenwick Plastics reports accounting profit of $2,000,000. Depreciation charged in the accounts is $400,000, while tax depreciation on the same assets is $650,000, a difference of $650,000 - $400,000 = $250,000. The tax rate is 25%.
Taxable profit is $2,000,000 - $250,000 = $1,750,000, so current tax payable is $1,750,000 x 25% = $437,500. The $250,000 timing difference creates an increase in the deferred tax liability of $250,000 x 25% = $62,500, because the faster tax relief taken now will reverse in later years.
Total tax expense in the income statement is $437,500 + $62,500 = $500,000, which is exactly 25% of the $2,000,000 accounting profit. The cash paid this year is only $437,500, and the $62,500 difference sits on the balance sheet as a liability until the timing difference unwinds.Case study
Seen in the real world.
This illustrative, fictional example follows Bellwether Interiors, a growing fit-out contractor preparing its first audited accounts before raising bank finance. Management had prepared a simple tax charge of 25% of accounting profit, giving $310,000 on a profit of $1,240,000, and had recorded no deferred tax at all.
The auditors found two significant timing differences: accelerated capital allowances on $1,100,000 of plant, and a $180,000 warranty provision not yet deductible. Once the tax computation was rebuilt, current tax fell to $214,000 while a net deferred tax liability of $96,000 was recognised, leaving the total tax expense at $310,000 and the reported profit after tax unchanged.
The reported bottom line was the same, but the balance sheet and the cash forecast were not. In this fictional case the bank's credit team focused on the $96,000 of tax deferred rather than avoided, and Bellwether's finance manager began producing a full tax computation quarterly rather than once a year.
Watch out
Common mistakes.
- Estimating the tax charge as the headline rate applied to accounting profit, which ignores disallowed costs and timing differences and usually gives the wrong number.
- Treating a deferred tax liability as a debt that must be settled on a date, when it only unwinds as the underlying timing difference reverses.
- Recognising a deferred tax asset on losses that the business has no realistic prospect of using, which overstates both assets and profit.
Questions
People also ask.
What is the difference between current tax and deferred tax?
Current tax is the amount payable on this period's taxable profit, while deferred tax accounts for tax effects that will crystallise in future periods.
Why does the tax charge in the accounts differ from the tax actually paid?
Timing differences, payments on account and prior-year adjustments all separate the accounting charge from the cash movement.
Does tax accounting reduce the tax a business pays?
No, it measures and presents tax correctly; reducing tax is the job of legitimate planning around reliefs, timing and structure.
From the founder's library
Take it further with the book.
Build your financial confidence beyond this definition. Shihan's full-length guide, Accounting Fundamentals, takes the same plain-English approach and turns it into a complete, practical playbook for non-finance managers, business owners and students - with chapter-end quiz answers and presentation slides included.
25% off with code MMHQ25, applied at checkout. Priced in USD - checkout may show the equivalent in your local currency.
View the book and save 25%