Deferred Tax: Why Book Profit and Taxable Profit Differ

Deferred tax is the tax effect of timing differences between the profit a business reports and the profit it is taxed on. When the tax rules allow a cost sooner than the accounts do, less tax is paid now and a liability is recorded for the tax that comes later. When the reverse happens, an asset is recorded instead. Deferred tax moves reported profit without moving cash.

Here is what sits underneath that. Two rule books measure the same twelve months of the same business. The accounting standards fix reported profit; the tax law fixes taxable profit. On most items the two agree in total and disagree only about which year the amount belongs to, and deferred tax is the bookkeeping that keeps the tax charged against profit in step with the profit itself rather than with the payment.

Anjani Stationers Private Limited, an invented stationery business, charges Rs 8,00,000 of tax against its year two profit, and only Rs 6,20,000 of it left the bank. The Rs 1,80,000 that did not is deferred tax, and every rupee of it traces back to one delivery van. What follows separates a difference that reverses from one that never does, shows which of the two produces deferred tax and which merely changes the rate, builds the Rs 1,80,000 from the van that caused it, and states exactly what has to be true before a deferred tax asset is worth the number printed beside it.

What is deferred tax, in one sentence?

Deferred tax is the tax on the difference in timing. Nothing more mysterious than that, and the definition survives every complication the subject produces. The accounts count a cost in one year; the tax computation counts the same cost in a different year; the total over the whole life of the item is the same on both counts. Deferred tax records the tax effect of that gap so that the tax charge sitting under the profit in the accounts belongs to that profit rather than to a payment schedule set by somebody else.

Deferred tax exists because the tax charge shown in the accounts has to answer to the profit shown in the accounts, and the amount actually paid answers to a different measure of profit entirely. Think of a household that pays its annual insurance premium in April. The money leaves in one month, and the cover lasts twelve. Nobody thinks the household spent all its insurance in April; the cost belongs across the year, and the April payment is a separate fact about the bank account. Deferred tax does the same job for tax. The payment date is one fact. The year the tax belongs to is another. When the two disagree, deferred tax is what carries the difference across.

Why do book profit and taxable profit differ at all?

Deferred tax differences: two rule books measuring one year

Book profit and taxable profit differ because the two rule books were written by different people for different purposes. The accounting standards are trying to describe a year of trading faithfully to whoever reads the accounts. The tax law is trying to raise revenue, discourage some kinds of spending and encourage others, and it does that by allowing some costs earlier, some later and some never. Neither is wrong. The two rule books are answering different questions, and the answers are two different profit figures for one identical year. The gaps between them are the deferred tax differencesThe individual items on which the accounting measure of a year and the tax measure of the same year disagree, each one either a matter of timing or a matter of permanent exclusion. the whole subject is built on.

Every difference between the two profit figures is one of exactly two kinds, and which kind it is decides everything else about how it is treated. Either the item will eventually appear on both measures and the disagreement is only about which year, or it will appear on one measure and never on the other. One test, does the item ever come back, separates the two kinds cleanly, and there is no third category to worry about. Anjani Stationers' year two carries one of each: the van is a timing disagreement, and the Rs 2,00,000 of expenses the tax rules refuse is a permanent one. The losses of Chitra Binding, the group's invented subsidiary, are a third thing again, a relief rather than a difference in measurement, and they are dealt with separately below.

Setting out the year two computation as rows makes the two profits visible at once. The starting point is what the accounts report, and each adjustment below it is one of the disagreements. The illustrative rate applied at the end is 25 per cent.

What is a temporary tax difference, and what is a permanent one?

Temporary tax differences

A temporary differenceA disagreement between the accounts and the tax computation about which year an amount belongs to, where the totals over the whole life of the item come out the same on both measures. is a disagreement about the year, never about the amount. The tax rules allow a machine faster than the accounts write it down, or refuse a provision until the money is actually spent, or tax a receipt when it arrives rather than when it is earned. In every one of those, the same rupee eventually shows up on both measures. Add up the whole life of the item and the two columns reach an identical total. The definition is worth memorising in exactly those words: same total, different years.

A temporary difference always comes back, and for exactly that reason it is the only kind that produces deferred tax. The coming back has a name of its own. The reversalThe later year or years in which a timing disagreement unwinds, so that the item the accounts and the tax rules put in different years finally reaches the same total on both. is the later year in which the gap closes. Think of a shopkeeper who takes an advance in March for goods delivered in June. The money is in the till now and the sale is recorded later, and by June the two views agree completely. Nothing was gained or lost; the calendar just had to catch up. A temporary tax difference is the same event wearing a tax label, and deferred tax is the entry that stops the reported profit lurching about while the calendar catches up.

Permanent differences

A permanent differenceAn amount that appears on one measure of profit and never on the other, in any year, so no later year brings the two measures back together. never comes back. An expense the tax law simply refuses is charged in the accounts and is not deducted in any year, ever. A receipt the tax law exempts is income in the accounts and is never taxed, in this year or another. There is no reversal because there is nothing left to reverse. Anjani Stationers' Rs 2,00,000 of disallowed expenses is exactly this: charged against profit in the accounts, added back in the tax computation, and gone. The Rs 2,00,000 raises the year's tax by Rs 50,000 at the illustrative 25 per cent, in the year it happened and in no other.

Permanent vs temporary tax differences

A temporary difference changes when tax is paid and creates deferred tax; a permanent difference changes how much tax is paid in total and creates none. That is the whole contrast and it decides the accounting treatment on its own. The test applied to every item is a single question: will any future year bring this back? If yes, it is temporary, deferred tax is recorded, and the reported tax charge stays matched to the reported profit. If no, it is permanent, no deferred tax is recorded, and the item simply shifts the proportion of profit that tax takes. A reader who confuses the two ends up looking for a deferred tax entry that was never going to exist.

How does a temporary difference create a deferred tax liability?

Follow the van. Anjani Stationers charges Rs 5,00,000 of depreciation on its delivery van in the year two accounts. Tax writes vehicles down faster than the accounts do, and the tax rules allow Rs 12,20,000 on the same van in the same year. To keep the comparison clean, assume the amount still to be written off is Rs 25,00,000 on both measures at the start of year two, so nothing is carried in from earlier disagreements. The gap this year is Rs 7,20,000, and it is entirely a matter of timing: over the van's remaining life the accounts will charge Rs 25,00,000 and the tax rules will allow Rs 25,00,000, to the rupee.

Taking Rs 7,20,000 more against tax this year means paying less tax this year and more tax in the later years when the van has nothing left to allow, and a deferred tax liabilityThe recorded tax effect of a timing disagreement that has lowered the tax computed for this year and will raise it in a later one, so the amount is owed to a future year rather than to this one. of Rs 1,80,000 is the record of that later tax. The arithmetic is one line: Rs 7,20,000 at the illustrative 25 per cent is Rs 1,80,000. The Rs 1,80,000 is charged against profit this year as part of the tax expense even though nobody paid it. The relief that reduced this year's payment was borrowed from later years, and the charge is the price of the borrowing. Deferred tax also leaves a balance carried in what the business shows at a date, and that presentation is covered under the balance sheet.

A single year hides the point. Watch the whole life of the van. The two columns below are different in every single year and identical in total, and the deferred tax liability underneath them builds and then unwinds all the way back to nothing. The tax schedule is illustrative, chosen to show the shape rather than to state any authority's rate.

How does a difference create a deferred tax asset instead?

Turn the same mechanism around. Whenever a business has paid tax on something the accounts have not yet charged, or has a cost the accounts have already charged but the tax rules will only allow later, the relief lies in the future rather than the past. A provision for warranty repairs is the everyday example: the accounts charge it the moment the sale is made, and the tax rules commonly wait until the repair is actually done. Tax this year is therefore higher than the accounts alone would suggest, and a lower charge is coming.

A deferred tax assetThe recorded tax effect of a difference or an unused loss that will reduce the tax of a later year, so the benefit sits in the future rather than in the year it is recognised. records tax relief expected in a later year, and unlike a liability it is only worth its number if there is future profit for the relief to be set against. That last clause is the entire difficulty of the subject, and it is why deferred tax assets get scrutiny that deferred tax liabilities never attract. A liability will collect itself: the tax authority does not need the business to prosper before it can charge more tax later. An asset needs something specific to happen first, namely enough taxable profit in future years to absorb the relief. Without that profit the asset is a claim on nothing.

The clearest source of a deferred tax asset in this group is the subsidiary. Chitra Binding came into the group carrying Rs 14,00,000 of accumulated tax losses from its years before acquisition. Rs 8,00,000 of those were set off in the year two tax computation, the same Rs 8,00,000 that takes taxable profit down in the table above, and Rs 6,00,000 remains unused. At the illustrative 25 per cent, that remaining Rs 6,00,000 would support a deferred tax asset of Rs 1,50,000. The word supporting is doing real work there: the asset is recognised only to the extent that future profits are expected to be available to use the losses against. Here the losses reduce the tax computed for the year without any previously recognised asset unwinding. The whole of the year's Rs 1,80,000 deferred charge therefore comes from the van and none of it from the losses.

Deferred tax asset vs deferred tax liability: which one is it?

Two questions settle it every time, in this order. First, has this year's tax computation been made smaller or larger than the accounting profit alone would imply? Second, will a later year get the opposite treatment? Smaller now and larger later is a liability. Larger now and smaller later is an asset. The labels are just names for the two answers, so once the two questions are asked there is nothing left to remember.

Only the asset depends on a future that has not happened yet, so the two are mirror images in mechanism and nothing alike in reliability. Hold that distinction and most of what practitioners argue about becomes legible. A large deferred tax liability is a scheduling fact. The business has been allowed to keep cash early and will hand it over later. A large deferred tax asset is a forecast. The business has handed cash over early, or has losses banked, and is expecting to be given relief later. One of those is arithmetic and the other is a judgement about years nobody has lived through.

What is cash tax, and how does it differ from book tax?

Cash tax

Cash taxThe tax computed on the taxable profit of the year and payable to the tax authority for it, the amount that actually moves rather than the amount charged against reported profit., also called current tax, is the tax computed on the taxable profit of the year and payable for that year. For Anjani Stationers it is Rs 6,20,000, being Rs 24,80,000 of taxable profit at the illustrative 25 per cent. Cash tax is the figure the tax authority is interested in, the figure the treasury has to fund, and the figure a cash forecast has to carry. The tax rules decide it entirely, and what the accounts thought about the year does not come into it.

Cash tax vs book tax

Book taxThe total tax expense charged against the profit reported in the accounts, made up of the tax computed for the year plus or minus the deferred tax movement. is the total tax expense charged against profit in the accounts, and for Anjani Stationers it is Rs 8,00,000. Book tax is not a payment. Book tax is cash tax plus the deferred movement, and here that is Rs 6,20,000 plus Rs 1,80,000. Rs 6,20,000 left the bank and Rs 1,80,000 did not, and only one of those two facts is visible on the face of the profit statement. A reader who takes the Rs 8,00,000 as the year's tax payment has overstated the cash going out by Rs 1,80,000. On a business of this size that is most of a month's employee cost.

Three settings of the slider carry the whole lesson. Set the tax depreciation to Rs 20,00,000 and the temporary difference is Rs 15,00,000, the deferred tax liability movement is Rs 3,75,000, and cash tax falls to Rs 4,25,000 while the charge against profit stays at Rs 8,00,000. Set it to Rs 5,00,000, exactly equal to the accounts, and the difference disappears: there is no deferred tax at all and cash tax is the whole Rs 8,00,000. Set it to nothing and the direction flips: a deferred tax asset movement of Rs 1,25,000 arises and cash tax rises to Rs 9,25,000. Across the whole range the total charged against profit never moves by a single rupee. Deferred tax splits a charge; it does not create one.

When can a deferred tax asset be a red flag?

Why deferred tax assets can be a red flag

Start with what the asset actually promises. The asset says that a later year's tax will be lower than that year's profit would otherwise have produced. The promise can only be kept if there is a later year with profit in it. The arithmetic is usually right. The question every deferred tax asset invites is whether the profit it depends on is likely, and that question has a name: recoverabilityWhether an amount recorded as an asset will actually turn into a benefit, which for a deferred tax asset means whether enough future taxable profit is expected for the relief to be set against..

A deferred tax asset that keeps growing while the business keeps losing money describes a pattern in which the evidence for future profit is getting weaker at exactly the same time as the amount depending on it gets larger. Notice what is and is not being said. No accusation is being made about anyone's judgement, and a business can be loss making for perfectly ordinary reasons while a recovery is genuinely in prospect. The point is narrower and it is about the direction of two lines. Unused losses are the raw material of the relief, so losses build the asset. Losses also erode the case that there will be profit to use it against. The same event pushes the number up and the justification down, and that is why the combination is worth a question rather than a shrug.

In practice a careful reader asks three things and stops. First, what future profit is this asset assuming, over what period? Second, where does that profit come from, given the record of the last few years? Third, has the recognised amount been trimmed in any year, or has it only ever grown? None of the three is answered by the tax note's arithmetic. All three are answered by the business's own record of profitability beside it. A deferred tax asset is therefore one of the few figures a reader should look away from the tax note to assess.

What is Anjani Stationers' deferred tax this year, and where does it come from?

Everything above assembles into a single small computation, and it is worth running from both ends because a build that only works in one direction has usually hidden something. Start from the van, arrive at the tax expense; then start from the tax expense and get back to the van. The illustrative rate is 25 per cent throughout.

Rs 6,20,000 of cash tax plus Rs 1,80,000 of deferred tax is Rs 8,00,000, the tax expense sitting on the year two ladder above the reported profit of Rs 30,00,000, and the whole of the Rs 1,80,000 is traceable to one van. That traceability is the test of whether the year has been understood. Every rupee of the deferred charge has a physical cause that can be pointed at, and if a deferred tax movement in any set of accounts cannot be traced to something specific, that is the moment to read the tax note more slowly rather than faster. Chitra Binding's remaining Rs 6,00,000 of losses sits outside this computation entirely: it would support a deferred tax asset of Rs 1,50,000 and is recognised only to the extent future profits are expected to absorb it.

How does an analyst actually use the deferred tax line?

Step out of the classroom. Deferred tax is not an idea anyone admires. Deferred tax is a figure people use in rooms where money is decided, and three different readers use it for three different purposes. A lender funding working capital wants to know what the treasury has to find. An analyst comparing two businesses wants to know whether a low tax charge is real or borrowed. Somebody assessing the quality of reported profit wants to know how much of the year's earnings depended on a judgement rather than a transaction.

The practical use of the split is that cash tax states what the bank account has to survive and the deferred movement states what the accounting charge has borrowed from later years, and neither figure answers the other's question. Anjani Stationers is a clean illustration. A lender modelling the coming year would fund Rs 6,20,000, not Rs 8,00,000, and would then ask when the Rs 1,80,000 turns into a payment. The van schedule answers that: the balance keeps building for one more year and starts unwinding after that. An analyst seeing a business with cash tax persistently far below its book tax would want to know whether the gap comes from a genuine acceleration that will reverse, as here, or from something that keeps being renewed by new spending each year. The renewed kind looks like a permanent saving and is not one.

Anjani Stationers Private Limited, Chitra Binding Works Private Limited, Anjani Kulkarni, Meera Rao and the Sunrise Public School group are invented, as are the loss making business in the red flag illustration and the workshop in the failure.
Educational material. Not advice on any investment, tax, budget or market position.