BAJAJ BROKING
March 07, 2025
9 mins read
Deferred tax is an important accounting concept, which can help you analyse a company’s financials well. Usually, deferred taxes arise on account of differences between how certain Read more..income and expenses are treated for accounting and tax purposes.
For example, the tax laws in a country may require a firm to record an expense on its payment. However, the accounting rules may require an expense to be recognised when it becomes due. Such differences result in creating deferred taxes. Read less
Deferred tax is an important item in a company’s income statement and balance sheet. However, it is often misunderstood. Some people even think it is not of a major consequence. In reality, deferred tax is not difficult to understand. Besides, it can have a significant impact on a company’s financials. Hence, in this blog, we will demystify this topic with the help of examples and also deal with misconceptions surrounding it.
If you check the accounting statements of companies, you will often come across this term – Deferred Tax. Deferred taxes come into being because of differences between how certain income or expenses are treated for tax and accounting purposes.
Let us say that a company has to record a certain income in the current financial year as per accounting regulations. However, according to tax rules, it should record this income in its books in the next financial year.
Therefore, the company’s profit as per accounting regulations will be higher this year than its profit as per tax rules. As a result, it will show a higher payable tax in its accounting books compared to the tax it will actually pay to tax authorities for the current financial year. So, it has shown more tax but paid less. Therefore, it must recognize a deferred tax liability.
Let us take a different example. Suppose a company has to record a certain expense in its books as per accounting regulations in the current financial year. However, tax laws require it to record this expense only in the next financial year.
Therefore, its profit as per accounting regulations will be lower than that as per tax laws in the current year. Hence, it will record less tax in its accounting books than it will pay to tax authorities. So, it should record a deferred tax asset.
There are two main categories of deferred tax: deferred tax assets and deferred tax liabilities. It is important to understand these terms thoroughly.
Deferred Tax Assets: At times, a company shows a lower tax payable on its accounting profit than on the profit in its income tax return. Hence, it pays more tax to authorities than it records in its books of accounts. So, to deal with it, it has to record a deferred tax asset in its accounting books in the current financial year.
Deferred Tax Liabilities: Often, companies face a situation in which the tax on their accounting profit is higher than the tax they have to pay to authorities in the current financial year. The lower tax they actually pay to tax authorities this year has to be paid at some point in the future. So, to adjust it, they record a deferred tax liability.
In order to understand the root cause of deferred tax, we need to understand the reasons behind it, which are explained below:
Differences in Depreciation Methods
A deferred tax is usually created due to a difference between the approach to depreciation of assets prescribed by the income tax laws and by the prevailing accounting regulations. Let us take an example to understand it better.
Suppose a company calculates depreciation on its assets using the accelerated depreciation method; however, the tax laws require it to follow the straight-line method. Its machinery has a current value of ₹ 1 crore with a 5-year lifespan and no salvage value. And, it uses a 25% rate to calculate depreciation. Hence, it will record ₹ 25 lakhs depreciation in its accounting books. Since the tax laws use the straight-line method, the company should record ₹ 20 lakhs depreciation for tax purposes.
Because the tax laws require the company to record a lower depreciation amount than accounting regulations, the profit according to tax laws should be higher. Therefore, the actual tax the company will pay to authorities will be higher than the tax in its accounting books. Therefore, it will recognize a deferred tax asset.
Accrued Expenses and Revenues
Let us understand how accrued expense or revenue results in creating deferred tax assets and liabilities. For certain accrued expenses, a company can get a tax deduction only when they are actually paid. However, for accounting purposes, such accrued expenses are recorded when they are due.
Since these expenses are not recorded this year from a tax viewpoint, it will inflate the profit. Hence, the company will pay a higher tax this year to authorities. To deal with it, it should recognise a deferred tax asset in the current year.
Now, let us take an example to understand how accrued revenues create deferred tax. Suppose a company is expected to receive a certain revenue in the current financial year; however, it will actually receive the revenue only in the next year.
As the company will receive the revenue only the next year and hence will actually pay tax on it in the next year, it should record a deferred tax liability this year in anticipation for paying tax next year.
The concept of deferred tax is extremely important in finance. First, deferred tax helps a company account for future tax consequences in its books in the current financial period. If not for deferred tax, no analyst, regardless of his ability, will be able to understand how a company’s financials will impact its tax liability in the future.
Second, companies can strategically plan for taxes and optimize tax liabilities over a period of time by being cognizant of deferred taxes. Last but not least, by recording deferred taxes on its books, a firm ends up complying with both tax laws and accounting regulations. If a company does not follow both accounting and tax regulations, it could result in financial and legal repercussions, which are avoidable by recording deferred taxes.
The best way to understand how deferred tax is calculated is by taking an example. So, please consider the table provided below. It shows you the income statement of a company based on accounting rules and tax laws.
Particulars | As per Accounting Rules (₹) | As per Tax Laws (₹) |
Total income | 2000000 | 2000000 |
Expenses | 1300000 | 1300000 |
Gross profit before depreciation and tax | 700000 | 700000 |
Depreciation | 150000 | 100000 |
Gross Profit after depreciation | 550000 | 600000 |
As you can see, the company has recorded ₹ 150000 as depreciation as per accounting rules but only ₹ 100000 as per tax laws. Hence, it has recorded ₹ 50000 as extra depreciation as per accounting rules. Therefore, its gross profit after depreciation is ₹ 50000 less as per accounting rules compared to what it is according to tax laws. Suppose, it pays tax at the rate of 20%. As its profit is more as per tax laws, it will pay more tax at the rate of 20% on ₹ 50000 (i.e., ₹ 10000) in this year than its books of accounts will show. Hence, it should record a deferred tax asset of ₹ 10000.
Deferred taxes significantly impact the financial statements of companies. They result in temporary differences between how accounting rules and tax regulations recognize certain income/expenses.
When a company pays more tax due to tax laws than due to accounting rules, it records a deferred tax asset, which means that it will receive a tax benefit in the future. Conversely, if it pays less tax due to tax laws than it should based on accounting rules, it records a deferred tax liability, which shows that it will pay more tax in the future.
Deferred tax also affects the tax expense on a company’s balance sheet. A firm must adjust its tax expense on its profit & loss account whenever it records a deferred tax asset or a liability.
Investors have to be especially concerned about a company’s deferred taxes. For example, if a firm has a significant deferred tax liability, it shows that it will pay a huge tax liability in the future.
Recent amendments to deferred tax regulations have introduced key changes impacting financial reporting. The Ministry of Corporate Affairs (MCA) updated Ind AS 12 – Income Taxes, enhancing clarity on recognizing deferred tax assets (DTA) on unrealized losses and fair value adjustments. The introduction of Sections 115BAA and 115BAB offered concessional tax rates, prompting companies to remeasure deferred tax liabilities. The phasing out of tax holidays and changes to Minimum Alternate Tax (MAT) applicability require businesses to reassess deferred tax accounting.
Global tax reforms, including the OECD’s BEPS framework and the introduction of the 15% Global Minimum Tax, impact multinational corporations' deferred tax reporting. Additionally, compliance with IFRS 16 (Lease Accounting) has altered how leased assets affect deferred tax calculations. These updates require companies to maintain transparency, adapt to evolving regulations, and ensure accurate financial reporting to optimize tax planning and avoid compliance risks.
There are a lot of misconceptions about deferred tax, which you need to be mindful of:
Deferred taxes do not impact future cash flows: A lot of people believe that deferred taxes have no impact on future cash flows of a company, which is far from the truth. In reality, a deferred tax asset means that a company will have cash inflow on account of taxes in the future. On the other hand, a deferred tax liability means that a company is likely to have a cash outflow due to taxes in the future.
Deferred tax is only a book entry with no real meaning: At times, people also argue that deferred tax has no real meaning and it is only a book entry. This is a misconception. As already explained in this blog, deferred tax can have a huge impact on a firm’s future cash flows.
Deferred tax only impacts large companies: Whether a company is large or small, it can have deferred tax. This is because deferred tax arises due to timing differences between accounting and tax treatments of certain income and expenses. While the amount of deferred taxes can be significant for large companies, small companies can also report deferred tax.
If you are about to open a demat account and begin trading in the stock market, you should learn the concept of deferred tax because it can help you analyse the financials of companies well. Even if you are a seasoned investor, you must know how to assess a company’s performance with deferred tax on its books because it can affect its future cash flows.
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This content is for educational purposes only. Securities quoted are exemplary and not recommendatory.
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Deferred tax represents a tax obligation or benefit that can occur in the future. It occurs due to the timing differences between how tax laws and accounting regulations recognize certain income and expenses.
Both deferred tax assets and liabilities appear on a company’s balance sheet. While deferred tax assets reduce a company’s future tax payments, deferred tax liabilities increase its future tax payments.
Typically, deferred tax liabilities are caused by differences between tax laws and accounting regulations regarding how to deal with depreciation and revenue & expense recognition.
It can happen that accounting rules in a country prescribe one method of recognizing depreciation, while tax laws recommend another method, which can result in deferred tax.
Deferred taxes impact a firm’s future tax obligations or benefits, which in turn can impact its profitability and cash flows. Hence, understanding them is important for investors.
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