Deferred tax

What it means

Deferred tax records the future tax effect of differences between the accounting and the tax view of the same item. Typical cases are accounting versus tax depreciation, provisions not recognised when created, or a tax loss carried forward.

These differences are temporary: they reverse eventually. Deferred tax is therefore booked as a deferred tax liability or asset and has nothing to do with what the company pays for the current year.

Deferred tax arises only from temporary differences. Permanent differences, such as non-deductible expenses on entertainment or fines, never reverse, because they will not be deductible in future either; they increase the current year’s tax payable but create no deferred tax and stay out of its calculation.

How it works in practice

Entities defined in the rules must account for it - chiefly those subject to audit and companies in groups reporting under IFRS. Others may do so voluntarily, with the policy fixed in an internal rule.

The calculation is done at the annual closing from a schedule of temporary differences and the corporate income tax rate expected when they reverse. A deferred tax asset is recognised only where future profit is probable.

We keep the schedule of temporary differences item by item and carry it forward from year to year. For each machine we compare the accounting and tax net book value, for provisions the amount that becomes deductible only when used, so the year-end calculation is a review of movements rather than fresh work from scratch.

What to watch out for

Deferred tax confuses readers of the statements: it raises or lowers reported profit while changing nothing in the bank account. So in assessing performance the current and deferred parts of tax are looked at separately.

When the income tax rate changes, the whole deferred tax balance has to be remeasured at the rate that will apply when the differences reverse. A company that skips the remeasurement carries the asset or liability at the wrong amount, and the effect of the change is also missing from the notes to the financial statements, which the auditor will pick up.