Deferred tax

The tax expense in a company's income statement is rarely the tax it paid. Not because of avoidance — because accounting profit and taxable profit are two different computations of two different things.

The accounts follow Ind AS. The tax return follows tax law. They disagree, and deferred tax is the bookkeeping that reconciles them over time.

Two kinds of difference

Permanent differences never reverse. An expense disallowed for tax forever, or income exempt forever. These simply make the effective tax rate differ from the statutory rate, and no asset or liability arises.

Temporary differences reverse in later periods. The same rupee is recognised in both systems, in different years. These create deferred tax.

The classic case is depreciation. A company might depreciate an asset over 15 years in its accounts and claim tax depreciation faster. Over the asset's whole life both systems allow the same total. In the early years the tax computation deducts more, so tax paid is lower than the accounting charge implies — and the difference will reverse later.

The two balances

A deferred tax liability arises where a temporary difference means more tax will be paid in future than the current charge suggests. The accelerated depreciation case: tax relief was taken early, so later years will bear more tax. The obligation is real and the standard requires recognising it.

A deferred tax asset arises the other way — where future tax will be lower because of something already recognised in the accounts. Unused tax losses are the most common source.

ICAI states the recognition rule for the asset carefully: a deferred tax asset is recognised for deductible temporary differences to the extent that it is probable that taxable profit will be available against which the deductible temporary difference can be utilised.

Why the asset is the interesting one

Read that condition again. A deferred tax asset is only worth something if the company earns future taxable profit. A tax loss is not refundable cash; it is a right to pay less tax later, and only if there is a later profit.

So recognising a large deferred tax asset is, implicitly, management asserting a forecast of profitability.

That gives the problem its answer. A company with accumulated losses carrying a large deferred tax asset is saying it expects to become profitable enough, soon enough, to use them. Grounds for doubt:

• Several consecutive loss-making years with no clear turn
• The asset growing each year as losses accumulate, with no utilisation
• An expiry horizon on the losses approaching
• The forecast resting on a business plan rather than on evidence

If the expectation fails, the asset is written down, and that write-down is a charge to profit — in the year the company could least absorb it. This is one of the more reliable late-stage warning signs in a struggling business.

Reading the tax note

Two things make the whole area readable without any computation.

The effective tax rate reconciliation. The note walks from the statutory rate to the rate actually charged, line by line. Large or unexplained items there are the first place to look — and a company whose effective rate is persistently far below statutory should have an explanation you can follow.

The deferred tax movement. Opening balance, charged, released, closing, split by the differences causing it. A deferred tax asset that keeps growing and never gets used is the pattern described above.

Why it is not cash

Deferred tax is an accrual, not a payable. It is not money owed to the tax authority today and it is not money the tax authority owes the company. It is the accounting system acknowledging that the two profit computations are temporarily out of step and will catch up.

That is why chapter 14 removes it when building the cash flow statement, alongside depreciation, as a non-cash item.

The point

Accounting profit and taxable profit follow different rules, and temporary differences — timing differences that reverse — are what deferred tax records. A deferred tax liability means more tax will be paid later than the current charge implies; a deferred tax asset means less, and it is recognised only to the extent that future taxable profit is probable. That makes a large deferred tax asset at a loss-making company a management forecast sitting on the balance sheet.