Deferred tax and temporary differences

A Footnotes Analyst guide for investors

Deferred tax can have a significant impact on the tax charge and hence net income. Although confusing and complex, we think that deferred tax provides very relevant information for investors.

In this Footnotes Analyst guide we provide a simple explanation of deferred tax in the balance sheet and income statement, and demonstrate how deferred tax adjustments are derived from so-called temporary differences.

The need for deferred tax mainly arises from the different way in which income and expenses are reported in financial statements compared with their effect on taxable profit. Tax accounting is not the same as financial accounting.

Even though the effect of a transaction on accounting pre-tax profit and taxable profit may be the same in aggregate over time, the amounts in any one period may differ. These ‘timing differences’ mean the current tax expense is not representative of the economic tax burden in the period – deferred tax adjusts for this. In effect, deferred tax adjustments result in the application of the accruals concept to corporate taxes.

Current tax may fail to fairly reflect the true tax impact of transactions reported in profit and loss

For example, if a transaction produces an expense that is recognised in the income statement over several years, but which gives an immediate deduction for tax purposes, current tax will initially be low compared with accounting profits, while in later periods the opposite occurs. This would produce a misleading profit trend where the tax expense in the first year understates the true economic effect. The deferred tax adjustment in this case would increase the tax charge in the initial period with a deferred tax liability reported. This liability is reversed, and a deferred tax credit (income) recognised in profit and loss in subsequent periods that offsets the higher cash tax payments.

The net result of deferred tax adjustments is to produce a total tax charge that better reflects the tax impact of transactions reported in profit and loss in each period.

Although characterising deferred tax as a product of ‘timing differences’ is a good way to explain the concept, it is not how deferred tax in IFRS (or US GAAP) is actually calculated. Deferred tax balances in financial statements are calculated from temporary differences not timing differences. In most cases the result is the same, but not always.

The temporary difference approach involves comparing the balance sheet carrying values for assets and liabilities with their so-called ‘tax bases’. The tax base reflects the amount that is (or is not in the case of liabilities) recoverable for tax purposes. Probably the best way to explain the timing and temporary difference approaches, and how they mostly produce the same accounting outcome, is with a numerical example.

Deferred tax example – Timing versus temporary difference approaches

Assume that a fixed asset is purchased for 100. The asset has a 5-year useful life, an expected residual value of zero and is depreciated using the straight-line method. For tax purposes the cost of the asset can be deducted from taxable profit in two equal amounts in years 1 and 2.

Under the timing difference approach, the deferred tax charge or credit in profit and loss is the tax rate multiplied by the difference between the accounting expense and the tax allowance in each period. The deferred tax balance in the balance sheet is the cumulative amount of the income statement effect.

For the temporary difference approach the deferred tax balance is calculated from the difference between the tax base and accounting carrying value of the asset. Changes in this deferred tax balance determine the amount recognised in profit and loss. In this example, the deferred tax calculated from temporary and timing differences is the same. This is not always the case – there are some transactions where the amounts differ.

Notice how current tax (tax payable in respect of the year) and the effective current tax rate is low initially (12.5% in year 1) and increases once the tax allowance ceases (24% in year 3). The effect of including deferred tax is to produce an effective tax rate that is more consistent with the economic burden of tax, in this case the statutory rate of 20%.

In practice, companies have multiple transactions that all create different and overlapping deferred tax effects and not just a single transaction as we illustrate above. What you see in financial statements is the aggregation of many adjustments. The effect is that the difference between the current and total effective tax rates is often less than we illustrate. Nevertheless, deferred tax fulfils an important function in ensuring that the overall tax reported in a particular period fairly reflects the tax burden of profit earned and that the future expected increase or reduction in taxes is recognised as a liability or asset in the balance sheet.

Taxable and deductible temporary differences

The example above results in a taxable temporary difference and a deferred tax liability. In periods after initial recognition the tax base of the asset is lower than the accounting carrying value, which results in a future tax deduction that is lower than the accounting expense and therefore higher tax payments. The deferred tax liability is the cumulative amount of those future increased payments.

While many transactions produce taxable temporary differences and deferred tax liabilities, some have the opposite effect, where the future tax deduction is higher than the accounting expense. This results in a so-called deductible temporary difference and a deferred tax asset.

For example, a deferred tax asset arises where an expense is recognised in profit and loss, but for which the tax deduction only occurs later. The incidence of this varies by tax jurisdiction but may arise for certain provisions, such as a provision for an environmental liability, where the tax deduction only occurs when the liability is settled (which may be some time after the point when the liability is established) and an expense reported. The deferred tax adjustment has a similar effect to that illustrated above, except that it is reversed with an initial tax credit in profit and loss and a deferred tax asset (representing the future expected tax savings) in the balance sheet

Tax base for a liability

Many transactions create deferred tax balances and deferred tax can arise from both assets and liabilities reported in the balance sheet. Where temporary differences arise from liabilities the calculations are reversed, which is one of the reasons many investors find the temporary difference method for deferred tax so confusing. The tax base of a liability reflects the amount that is not deductible for tax purposes. For example, if the settlement of a liability results in a tax deduction equal to the amount paid, the tax base of the liability is zero, whereas in the case of an asset the tax base would be the amount of that deduction.