What it calculates

Deferred tax accounts for the difference between accounting profit and taxable profit. Where an item is recognised in one period for books and a different period for tax, deferred tax records the future tax consequence today, so the tax expense in the accounts matches the profit reported alongside it.

How it is calculated

Compare the carrying amount of each asset and liability with its tax base. The difference is a temporary difference. Taxable temporary differences - where book value exceeds tax base, as with accelerated tax depreciation - create deferred tax liabilities. Deductible differences, such as provisions not yet allowed for tax or carried-forward losses, create deferred tax assets. Multiply by the tax rate expected to apply when the difference reverses, not today's rate.

How to read the result

The deferred tax asset is only worth recognising if future taxable profit will exist to use it, which is why a valuation allowance against it is one of the most judgement-heavy numbers in a set of accounts. A company releasing a large valuation allowance is telling you it now expects to be profitable, and that release flatters earnings without any operating improvement. On the liability side, a steadily growing deferred tax liability from depreciation is often effectively permanent as long as capital spending continues.

Worked example

An asset has a carrying value of 800,000 and a tax base of 500,000 because tax depreciation ran faster. The taxable temporary difference is 300,000, and at a 25% enacted rate the deferred tax liability is 75,000. If a 200,000 provision is booked but only deductible when paid, that creates a deferred tax asset of 50,000.

Common questions

What is the difference between a temporary and a permanent difference?

A temporary difference reverses over time - the total is the same, only the timing differs - and generates deferred tax. A permanent difference never reverses, such as a fine that is never deductible, and simply changes the effective tax rate without creating any deferred balance.

Which tax rate should be used?

The rate enacted or substantively enacted for the periods when the difference is expected to reverse. When a rate change is legislated, all deferred balances are remeasured in the period of enactment, which can produce a large one-off tax charge or credit unrelated to trading.

When is a valuation allowance needed against a deferred tax asset?

When it is more likely than not that some portion will not be realised. A history of recent losses is strong negative evidence that is hard to outweigh with projections, which is why loss-making companies often carry substantial unrecognised deferred tax assets.