Deferred Tax
Companies keep two sets of books — one for shareholders (financial accounting) and one for the tax authority (tax accounting). They use different rules, so the tax expense on the income statement rarely equals the tax actually paid. Deferred tax is the bridge. This lesson builds deferred tax liabilities and assets from temporary differences, covers recognition and valuation allowances, the effect of tax-rate changes, and the difference between statutory and effective tax rates.
On this page
The income statement reports tax expense (the tax on accounting profit); the tax return drives tax payable (the tax on taxable income). The gap is captured on the balance sheet as deferred tax, and the bridge is:
Learning outcomes
- Explain why tax expense differs from tax paid and compute deferred tax from temporary differences.
- Distinguish deferred tax liabilities from assets, and taxable from deductible differences.
- Apply DTA recognition rules and valuation allowances (IFRS vs US GAAP).
- Adjust deferred tax for a change in tax rates.
- Reconcile statutory and effective tax rates, including permanent differences and multi-country operations.
Carrying amount vs tax base
A temporary difference is the gap between an item's carrying amount (financial accounting) and its tax base (the value the tax authority assigns). It is temporary because it reverses over time. Deferred tax = temporary difference × tax rate.
The deferred tax liability
Faster tax depreciation creates a DTL
Equipment £100k, no residual. Accounting: straight-line over 4 years (£25k/yr). Tax: straight-line over 2 years (£50k/yr). Tax rate 20%; pre-tax-and-depreciation profit a steady £200k. Build the DTL.
Show solution
Carrying amount falls 75 → 50 → 25 → 0; tax base falls 50 → 0 → 0 → 0. Temporary differences 25, 50, 25, 0 → DTL = TD × 20% = 5, 10, 5, 0. On the income statement, tax expense is \(175\times20\%=35\) every year; tax payable is \(150\times20\%=30\) in years 1–2 (tax lets you deduct more, so less tax now) and \(200\times20\%=40\) in years 3–4. The DTL builds (ΔDTL = +5, +5) then unwinds (−5, −5). Because tax base < carrying amount of an asset, more tax is owed later — a liability. (Governments often grant accelerated tax depreciation to encourage early investment, recovered later.)
DTL = 5, 10, 5, 0; expense 35/yr vs payable 30, 30, 40, 40The deferred tax asset
The mirror image: when the firm overpays tax now (an expense recognised for accounting but not yet deductible for tax), it creates a deferred tax asset — a future tax saving.
A bad-debt allowance creates a DTA
2010: receivables £180, bad-debt allowance £30 (so carrying amount £150, a £30 charge in income). The tax authority deducts only actual write-offs, not the allowance. 2011: the firm collects £150 and writes off £30 (now tax-deductible). Pre-tax-and-bad-debt profit £100; rate 20%.
Show solution
2010: tax base of the receivable (180) > carrying amount (150) → temporary difference −30 → DTA = 30×20% = 6. Income statement: accounting profit \(100-30=70\) → tax expense \(=14\); taxable income \(=100\) → tax payable \(=20\). Tax payable (20) > tax expense (14) → £6 overpaid now, recovered later. 2011: the write-off is deductible, the difference reverses to zero, and the DTA is used. The same logic applies to a liability: prepaid rent of £50 taxed on receipt (carrying amount 50, tax base 0) creates a DTA of £10, released when the rent is recognised in income next year.
DTA = 6 (TD −30 × 20%); tax payable 20 > expense 14, recovered when written offTaxable vs deductible temporary differences
Taxable temporary differences create a future taxable amount → a DTL: an asset with carrying amount > tax base, or a liability with carrying amount < tax base. Deductible temporary differences create a future deduction → a DTA: an asset with carrying amount < tax base, or a liability with carrying amount > tax base. (The PPE example is the first; the receivable and prepaid-rent examples the latter two.)
Recognition and valuation allowances
A DTA is only worth something if there will be future profits to use it against. IFRS recognises a DTA (and unused tax losses/credits) only to the extent future taxable profit is probable, reducing the carrying amount if doubt arises (reversible if circumstances change). US GAAP recognises the DTA in full, then nets it down with a valuation allowance (a contra-asset) when it is "more likely than not" that part won't be realised — increasing the allowance reduces income; reversing it increases income, with significant managerial discretion.
Little Rock Software — reading the allowance
Net DTA fell from $135,250 (2009) to $126,250 (2010); the valuation allowance rose from $25,640 to $35,780. Did the firm's prospects of using its DTAs (A) rise or (B) fall in 2010?
Show solution
Gross DTAs in the notes actually rose (160,890 → 162,030); the net figure fell only because the valuation allowance increased. A bigger allowance means management judges it less likely the DTAs will be realised — so prospects fell (B). The valuation allowance is a window into management's own forecast of future profitability.
B — the rising valuation allowance signals worse prospectsNokia's 2014 net income jumped despite weak revenue and pre-tax losses. The cause: an income-tax benefit of €2.1bn from re-recognising previously unrecognised tax losses, credits and temporary differences — based on a renewed pattern of profitability in Finland and Germany. Without it, Nokia would have been loss-making. (Note: under IFRS, deferred tax is classified non-current and is not discounted.) When DTAs (re)emerge, ask: will the firm really generate taxable profit before the losses expire, and were the past losses a one-off?
Changes in tax rates
Because deferred tax = temporary difference × tax rate, a change in the enacted rate re-values both DTAs and DTLs. A rate cut reduces future tax payments (lowering DTLs) but also reduces the value of future deductions (lowering DTAs); a rate rise does the opposite.
A rate cut from 30% to 25%
A temporary difference of 2,571 carried a DTL of \(2{,}571\times30\%=771\). The rate falls to 25%.
Show solution
The DTL is re-measured at the new rate: \(2{,}571\times25\%=643\) — a fall of 128. For a firm with a net liability, a rate cut is good news (a smaller future obligation). The remeasurement runs through tax expense in the period of the rate change.
DTL 771 → 643; the rate cut lowers the liabilityStatutory vs effective (and cash) tax rates
Three rates: the statutory rate (the rate where the firm is domiciled); the effective tax rate = tax expense / pre-tax income (useful for forecasting earnings); and the cash tax rate = cash tax paid / pre-tax income (useful for forecasting cash flow). Temporary differences do not change the effective rate — in the receivable example it is 20% in both years, matching the statutory rate. Two things do move it:
- Permanent differences — items treated differently by tax that never reverse, so they create no deferred tax (e.g. a non-deductible pollution fine). They push the effective rate away from statutory: a £20 non-deductible penalty on £110 profit gives accounting profit £90, but taxable income £110, so tax \(=110\times30\%=33\) and the effective rate \(=33/90=\textbf{37%}\) vs a 30% statutory rate.
- Multi-country operations — the effective rate becomes a profit-weighted blend. Neutrino earns $1,000 in the US (21%) and $1,000 in Ireland (12%): tax \(=210+120=330\), effective rate \(=330/2{,}000=\textbf{16.5%}\).
Deferred tax in equity
If a DTL will never reverse — e.g. future losses mean no tax will ever be paid — it is no longer a real obligation: the DTL is reduced and the reduction taken directly to equity. From the analyst's standpoint, when both the timing and amount of a deferred tax balance are genuinely uncertain, the DTL should be excluded from both debt and equity when assessing leverage.
Deferred tax reconciles the shareholders' books to the tax return: \(\text{Tax expense}=\text{Tax payable}+\Delta\text{DTL}-\Delta\text{DTA}\). A DTL arises when an asset's carrying amount exceeds its tax base (pay less tax now, more later — accelerated tax depreciation); a DTA arises when you overpay now (an allowance not yet deductible, prepaid income taxed early). DTAs are only as good as future profits — recognised when probable (IFRS) or netted by a valuation allowance (US GAAP), a revealing window on management's forecasts (Little Rock, Nokia). Rate changes re-value the balances; and the effective tax rate departs from statutory through permanent differences and multi-country blending — while never-reversing balances belong in equity, or out of the leverage calculation entirely.