What Is Deferred Tax? A Real-World Example
Think of it this way: Your company buys a machine for $100,000. Under IFRS you depreciate it over 10 years ($10,000/year). Tax rules allow depreciation over 5 years ($20,000/year). In Year 1, your taxable profit is $10,000 lower than your accounting profit — but this difference will fully reverse by Year 6.
If this temporary difference is not recorded today, the financial statements fail to show the true tax burden. Deferred tax transfers the future tax impact of these temporary differences onto the current balance sheet.
Temporary vs. Permanent Differences
This distinction is critical — deferred tax is calculated only on temporary differences.
| Type | Definition | Deferred Tax? | Example |
|---|---|---|---|
| Temporary | Reverses over time | ✅ Yes | Depreciation difference, employee benefit provisions |
| Permanent | Never reverses | ❌ No | Non-deductible fines, certain donations |
📌 Practical note: Traffic fines and non-deductible donations are never allowed as a tax deduction. They create no deferred tax. Only differences that will reverse in a future period give rise to deferred tax.
Deferred Tax Asset (DTA) and Deferred Tax Liability (DTL)
🟢 Deferred Tax Asset — you will pay less tax in the future
Example: Employee Benefit Provision
The company accrued $80,000 in employee termination benefits this year. Under IFRS this expense is recognised now; under tax rules it is deductible only when paid.
| Item | Amount |
|---|---|
| IFRS expense (current year) | $80,000 |
| Tax deduction (current year) | $0 |
| Deductible temporary difference | $80,000 |
| Tax rate | 25% |
| Deferred Tax Asset | $20,000 |
🔴 Deferred Tax Liability — you will pay more tax in the future
Example: Accelerated Depreciation
Machine cost $200,000. IFRS: 10 years; Tax: 5 years.
| Year 1 | IFRS | Tax | Difference |
|---|---|---|---|
| Depreciation | $20,000 | $40,000 | $20,000 |
| Net book value | $180,000 | $160,000 | — |
Because tax allows more depreciation now, less tax is paid today. In Years 6–10 tax depreciation ends while IFRS depreciation continues, so more tax will be paid then.
DTL = $20,000 × 25% = $5,000
Journal Entries
Under IAS 12, deferred tax is accounted for using the balance sheet liability method. The entries affect profit or loss.
DTA entry (employee benefit provision example):
Dr: Deferred Tax Asset ........... 20,000
Cr: Deferred Tax Expense (Income) 20,000
(When benefits are actually paid — reversal:)
Dr: Deferred Tax Expense (Income) 20,000
Cr: Deferred Tax Asset ........... 20,000
DTL entry (accelerated depreciation example):
Dr: Deferred Tax Expense ......... 5,000
Cr: Deferred Tax Liability ........ 5,000
Common Mistakes
- ✗Treating permanent differences as temporary: Fines and non-deductible items never reverse and create no deferred tax.
- ✗Using the current tax rate: Always use the rate expected to be in force when the difference reverses.
- ✗Forgetting to re-measure existing balances: When the tax rate changes, all existing deferred tax balances must be remeasured at the new rate.
- ✓Correct approach: At each period-end, compare both the IFRS and tax carrying amounts of every asset/liability; if the difference is temporary, calculate deferred tax.