IAS 12 deferred tax: why your tax bill and your profit never quite match

IAS 12 deferred tax is the reason the tax figure in your accounts often does not match the tax bill you actually pay in a given year. If you have ever looked at your profit, applied the tax rate in your head, and wondered why the tax expense is different, this is usually the explanation. It is not an error, and it is not a second tax. It is accounting recognising that some tax effects belong to a different year than the cash payment.

IAS 12 deferred tax: the one idea behind it

The whole of IAS 12 deferred tax rests on one idea: accounting profit and taxable profit are calculated on different rules. Your accounts follow accounting standards. Your tax return follows tax law. The two rarely agree in the same year, even though over the life of an asset or a liability they usually catch up with each other.

IAS 12 deals with this through temporary differences. A temporary difference is the gap between what an asset or liability is worth in your accounts (its carrying amount) and what it is worth for tax purposes (its tax base). When that gap means you will pay more tax in the future, you recognise a deferred tax liability. When it means you will pay less tax in the future, you recognise a deferred tax asset — provided you are likely to have enough future taxable profit to use it.

That condition matters: a deferred tax asset is only recognised if future taxable profit is probable. A business with no realistic prospect of future profits should not carry one it will never realise.

IAS 12 deferred tax in a simple example

Take a machine, using round numbers purely to illustrate the mechanics. Suppose your business buys a machine for 120,000. In your accounts you depreciate it by 20,000 a year over six years. For tax purposes, though, the tax rules let you deduct 30,000 a year over four years.

After year one, the machine's carrying amount in your accounts is 100,000 (120,000 less 20,000 of depreciation). Its tax base is 90,000 (120,000 less 30,000 of tax deductions). The 10,000 gap is a taxable temporary difference: you have claimed more tax relief than accounting depreciation so far, so your future taxable profit will be higher than your future accounting profit as the difference unwinds. At an assumed tax rate of 20%, you recognise a deferred tax liability of 2,000.

Nothing extra is payable right now: the liability simply records 2,000 of tax deferred to later years, unwinding as accounting depreciation catches up with the tax deductions already taken.

The same logic works in the other direction. Suppose you recognise a warranty provision of 5,000 in your accounts, but tax law only allows the deduction when you actually pay the warranty claims. The provision's carrying amount is 5,000 and its tax base is nil, giving a deductible temporary difference of 5,000. At 20%, that is a deferred tax asset of 1,000 — future tax relief you have already earned in accounting terms but have not yet claimed on a tax return.

IAS 12 deferred tax: what it means for your business

First, it explains your tax expense. The tax expense in your profit and loss account is made up of current tax (the tax on this year's taxable profit) plus the movement in deferred tax. That is why the tax expense can be higher or lower than a simple percentage of accounting profit, and why comparing the two without deferred tax in mind leads to confusion.

Second, it affects your balance sheet too. Deferred tax balances sit there until the underlying differences reverse, measured at the tax rates expected to apply when the asset is realised or the liability is settled, based on rates enacted or substantively enacted by the reporting date. They are not discounted.

Third, it matters for cash planning. A growing deferred tax liability is a warning that some of today's lower tax bill is borrowed from tomorrow: the relief was taken early, and the tax will arrive later. A deferred tax asset is the mirror image — tax relief recognised now that will reduce a future bill, but only if the business earns the profits to use it.

Three mistakes to avoid

The first mistake is ignoring deferred tax altogether. Small businesses sometimes treat the tax return as the only tax figure that matters. That works for cash, but it understates future obligations and overstates how much of today's profit is truly available.

The second mistake is confusing deferred tax with tax owed now. A deferred tax liability is not a bill from the tax authority and it is not overdue. Treating it as an immediate payment distorts cash-flow planning just as badly as ignoring it.

The third mistake is assuming every deferred tax asset will be recovered. If your forecasts do not show enough future taxable profit, the asset should be reduced. Carrying an asset you cannot use flatters the balance sheet and sets up a write-down later.

What to ask your accountant

You do not need to calculate this yourself — that is your accountant's job, and the details depend on your country's tax law. But three questions will tell you whether it is under control: which temporary differences are driving our deferred tax balance, when do they reverse, and is our deferred tax asset supported by realistic future profits? If your accountant can answer those plainly, the figure in your accounts is doing its job: telling you not just what tax costs this year, but when the rest of it arrives.

This is a general explanation of the standard, not tax advice for your business — tax law varies by country, and your own position should be confirmed with your accountant.

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