What is Deferred Tax

What is Deferred Tax?

Deferred tax refers to the tax effects that arise due to timing differences between when an item is recognised in the financial statements and when it is recognised for tax purposes. In simpler terms, it reflects the tax obligations or benefits a company will pay or receive in the future due to these temporary differences in accounting rules.

These timing differences occur when the way a company recognises its income and expenses for financial reporting purposes differs from how the tax authorities allow it. As a result, companies often need to account for taxes that they will pay or receive at a later date.

Types of Deferred Tax

Deferred tax arises when there’s a difference between how income or expenses are recognised in a company’s financial statements versus how they’re treated under income tax rules. These timing differences don’t eliminate tax—they simply shift when tax is paid or recognised.

Deferred tax is broadly of two types:

1) Deferred Tax Liability (DTL)

A deferred tax liability is created when a company’s tax payable in the current period is lower than the tax expense shown in its financial statements—meaning tax is likely to be paid more in the future.

This typically happens when:

• the company claims higher depreciation for tax purposes than it does in accounting books (tax depreciation often differs from book depreciation), or
• income is recognised earlier in accounts but taxed later (less common than depreciation-related cases).

In simple terms, DTL is a “future tax obligation” that arises because the company has received a timing-related tax benefit today.

2) Deferred Tax Asset (DTA)

A deferred tax asset is created when a company’s tax payable in the current period is higher than the tax expense shown in its financial statements—or when the company has losses or expenses that can reduce future taxes. This means the company may pay less tax in the future.

Common scenarios include:

• carried forward business losses that can be set off in future years
• unabsorbed depreciation carried forward
• expenses recognised in books now but allowed as a tax deduction later
• provisions (like certain employee benefits) that are booked now but become deductible later under tax rules

A quick way to remember it:

1. DTL = tax saved now, paid later
2. DTA = tax paid now, saved later

How is Deferred Tax Created?

Deferred tax arises primarily due to temporary differences in how revenues and expenses are treated under accounting standards (such as IFRS or GAAP) versus tax regulations. These differences can be caused by various factors, such as depreciation methods, allowances, and the treatment of revenue.

1. Depreciation:

One of the most common causes of deferred tax is the difference in the depreciation methods used for tax reporting versus financial reporting. Tax laws often allow companies to use accelerated depreciation, which leads to larger deductions in the earlier years of an asset’s life. This reduces taxable income in the short term. However, for financial reporting, companies typically use straight-line depreciation, which spreads the deduction evenly over the asset's useful life.

As a result, the company will pay less tax in the short term but will eventually have to pay more tax as the depreciation deductions under tax law decrease over time. This creates a deferred tax liability because the company is deferring tax payments to the future.

2. Warranty Expenses:

Another example is the treatment of warranty expenses. A company may estimate and recognise warranty expenses in its financial statements based on expected future costs. However, tax authorities may only allow the company to deduct these expenses when they are actually incurred, not when they are estimated.

In this case, the company will have paid taxes on the full revenue in the current period but will only recognise the expense for tax purposes later. As a result, this creates a deferred tax asset because the company will receive a tax benefit in the future when it incurs the warranty costs.

3. Loss Carryforwards:

A company that incurs a tax loss in one period may be allowed to carry that loss forward to offset taxable income in future periods. This creates a deferred tax asset since the company will be able to reduce its future tax obligations by using the loss carryforward.
 

Benefits of Deferred Tax in Financial Reporting

Deferred tax isn’t a “tax-saving scheme” in itself - it’s an accounting mechanism. But it does offer real advantages in how a business plans, reports, and interprets its tax position.

1) More accurate profit reporting

Deferred tax helps match tax expense with the period in which income is earned, rather than simply reflecting the tax paid that year. This makes profits look more realistic -  especially for companies with big capex or fluctuating taxable income.

2) Better visibility of future tax impact

• DTAs and DTLs give management and investors a clearer view of what’s coming:
• A large DTL signals potential higher tax outgo later
• A meaningful DTA suggests future tax relief, if the business generates enough taxable income to use it

3) Improves comparability across years

Without deferred tax accounting, tax expense can swing wildly based on timing differences, making year-to-year comparisons messy. Deferred tax smooths the view so financial statements reflect business performance more consistently.

4) Supports planning and decision-making

When companies understand what’s driving deferred taxes (depreciation differences, carry-forward losses, provisions), it helps with:

• forecasting cash flows
• evaluating capital expenditure decisions
• anticipating tax payments in future periods

In short, deferred tax doesn’t change the total tax a company owes over time - but it improves clarity by showing when the tax effect is expected to hit.

How Deferred Tax Affects Cash Flow

Deferred tax impacts cash flow by delaying the actual tax payments or refunds. Here’s how it works:

Deferred Tax Liability (DTL): When a company records a deferred tax liability, it means that it will pay higher taxes in the future. While this doesn’t immediately impact cash flow, it signals that the company will face larger tax payments in the future, potentially affecting its cash position.

Deferred Tax Asset (DTA): On the other hand, when a company records a deferred tax asset, it indicates that it will pay lower taxes in the future. This could positively impact future cash flow, as the company will pay less tax in the years ahead.

In both cases, understanding the movements in deferred tax balances allows businesses to better forecast their cash flow and plan for any tax obligations or refunds.
 

Deferred Tax and Financial Analysis

For investors and analysts, understanding deferred tax is crucial for evaluating a company’s financial health. Significant changes in deferred tax balances may indicate potential changes in tax obligations, which can affect future profitability and cash flow.

Furthermore, companies that experience large deferred tax assets or liabilities might be signalling significant shifts in their operations, such as increased capital investment or changes in accounting policies.

Conclusion

In conclusion, deferred tax is an essential concept that reflects the differences between book income and taxable income. These differences arise due to temporary timing differences between how revenues and expenses are recognised for accounting purposes versus tax purposes. Deferred tax assets and liabilities provide a more accurate picture of a company’s financial situation, allowing businesses to better forecast their cash flow and plan for future tax obligations.

By understanding deferred tax, businesses can improve their tax planning, ensure more accurate financial reporting, and potentially enhance the way they manage future tax liabilities or assets.

Also Learn About: