Deferred tax

Deferred tax arises because the rules for measuring profit under accounting standards differ from the rules used to calculate taxable profit under tax law. These differences create a timing gap between when income and expenses are recognised for accounting purposes and when they are recognised for tax purposes, and deferred tax is the accounting mechanism that bridges that gap.

A deferred tax liability represents future tax the company will owe because it has paid less tax now than its accounting profit would imply. The most common cause is accelerated depreciation, where tax rules allow a company to write off an asset faster than its accounting depreciation, reducing the current tax bill but creating an obligation to pay more tax in later periods when the difference reverses.

A deferred tax asset represents future tax savings the company expects to realise. These arise from items such as carried-forward losses that can offset future taxable profit, or expenses recognised for accounting purposes before they become deductible for tax. A deferred tax asset is only as valuable as the company's ability to generate enough future taxable profit to use it, which is why a large deferred tax asset at a loss-making company should be treated with caution.

On the income statement, the total tax charge is split between current tax, the actual cash owed to authorities this period, and deferred tax, the non-cash adjustment reflecting the change in these timing differences. On the balance sheet, the accumulated deferred tax positions sit as deferred tax liabilities among non-current liabilities and deferred tax assets among non-current assets.

Deferred tax is one of the more technical areas of financial reporting and a frequent source of confusion because it is entirely an accounting construct. No cash changes hands when a deferred tax balance is created or adjusted. It exists purely to match the tax expense to the accounting period in which the related income or expense is recognised, and understanding it is essential to reconciling why a company's effective tax rate often differs from the headline statutory rate.