What it means
Accounting profit and taxable profit are calculated under different rulebooks, and they rarely match. Tax expense exists to charge each accounting period with a tax cost that matches the profit reported in that same period, rather than whatever the tax return happened to demand.
The charge has two components. Current tax is the amount actually due on this year's taxable income; deferred tax is the adjustment for differences that will reverse in later years, such as depreciation claimed faster for tax than for accounting, or a provision recognised now but only deductible when paid.
Analysts pay close attention to the relationship between tax expense and profit before tax, expressed as the effective tax rate. A rate that drifts well below the statutory rate usually signals credits, losses or foreign earnings taxed elsewhere, and the notes to the accounts should explain the gap.
For managers, the useful discipline is separating the reported charge from the cash flow. A business can report a large tax expense while paying very little cash tax, or the reverse, and treasury planning must follow the cash figure while performance reporting follows the expense.
In practice
Real-world examples.
Example
A listed retailer reports profit before tax of $120,000,000 and a tax expense of $22,800,000, giving an effective rate of 19%. Analysts note the statutory rate is 25% and dig into the notes, where a large one-off research credit accounts for most of the gap.
Example
A construction group records a deferred tax expense because it recognises long-term contract profit for accounting purposes earlier than the tax rules allow. Cash tax stays low this year, but the income statement charge rises so that reported margins are not flattered.
Example
A start-up with accumulated losses reports zero current tax on a small profit, since prior losses absorb the taxable income. Its tax expense line still moves, because using those losses reduces the deferred tax asset held on the balance sheet.
Formula
Calculation
Total tax expense = Current tax expense + Deferred tax expense
Effective tax rate = Total tax expense / Profit before tax
Worked example: a software company reports profit before tax of $4,000,000. Its tax return for the year produces a current tax charge of $760,000, which is the amount it genuinely owes for the period. Because it claimed accelerated depreciation on servers, it also records a deferred tax expense of $80,000, representing tax pushed into later years rather than escaped. Total tax expense is $760,000 + $80,000 = $840,000, so net profit is $4,000,000 - $840,000 = $3,160,000 and the effective tax rate is $840,000 / $4,000,000 = 21%. If the statutory rate were 25%, the $4,000,000 x 25% = $1,000,000 expected charge would be $160,000 higher than the reported figure, and the accounts would need to explain that reconciling difference.Case study
Seen in the real world.
The following is an illustrative and fictional situation. Palewick Instruments, an invented maker of laboratory equipment, reported profit before tax of $10,000,000 and a tax expense of $1,500,000, an effective rate of 15% against a statutory 25%.
An incoming board member asked the obvious question and got a clear answer. A $600,000 research credit and $400,000 of losses inherited with a recent acquisition together explained the whole $2,500,000 - $1,500,000 = $1,000,000 shortfall against the statutory charge. Neither item was recurring, and the finance director had already flagged that the effective rate would climb back towards 24% the following year.
The useful outcome in this fictional story was a change in reporting rather than in tax planning. Palewick began showing a plain-language reconciliation from statutory rate to effective rate in its board pack, so that nobody built a forecast on a tax rate that was never going to last.
Watch out
Common mistakes.
- Reading tax expense as the cash paid to the authorities. The cash figure appears in the cash flow statement and can differ substantially from the income statement charge.
- Dividing tax expense by revenue instead of by profit before tax. The effective tax rate is only meaningful against pre-tax profit.
- Assuming a low effective rate is always good news. It often reflects one-off items that will not repeat, so forecasts built on it will overstate future earnings.
Questions
People also ask.
Why is there a deferred tax component at all?
Because accounting and tax rules recognise income and costs in different periods, and deferred tax matches the charge to the profit it relates to.
Can tax expense be negative?
Yes, a company reporting a loss or releasing a valuation allowance can record a tax credit, which increases the reported result.
Where do I find the detail behind the number?
The tax note in the annual accounts sets out current and deferred components and reconciles the statutory rate to the effective rate.
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