Deferred Taxes
Why the tax expense on the income statement differs from the tax a company pays, what deferred tax assets and liabilities are, and what the tax note reveals.
The short version
Companies work out profit twice, once under accounting rules and once under tax rules, and the two rarely agree in any one year. When a difference is only a matter of timing, the tax on it is recorded as a deferred tax liability if it will be paid later, or a deferred tax asset if it will save tax later. Faster depreciation for tax is the classic source of a liability. Past losses are the classic source of an asset, and that asset is only worth something if the company earns enough to use it. The tax note shows the cash actually paid, why the tax rate differs from the standard rate, and whether a one-time tax item has inflated or reduced the year's profit.
By the end of this lesson, you'll be able to
- Explain why tax expense and tax paid differ, using a temporary difference
- Describe deferred tax assets, deferred tax liabilities, and the valuation allowance
- Use the tax note to judge whether a company's tax rate is likely to last
Why this matters
Income tax is usually one of a profitable company's largest costs, and the amount on the income statement is not the amount it paid. The gap sits on the balance sheet as deferred taxes. These lines confuse many readers, so they get skipped. That's a mistake, because tax is one of the more common sources of a one-time jump or drop in reported profit.
Two sets of rules
A company calculates its profit under accounting rules for its financial statements, and again under tax law for its tax return. The rules differ because they have different purposes. Accounting rules aim to show performance. Tax law raises revenue and encourages certain behaviour, such as investing in equipment.
Some differences never go away. A fine that can't be deducted for tax, or a tax credit for research, changes the tax bill permanently. Others are only timing: the same income or cost is counted by both sets of rules, but in different years. Those are called temporary differences, and they create deferred taxes. A deferred tax asset or liability represents the decrease or increase in tax payable in future years because of the differences that exist today.1
Worked example: depreciation
As Depreciation, Amortization, and Capital Spending noted, tax depreciation is often faster than the depreciation in the financial statements. Suppose a company buys a $100 million asset. Its financial statements depreciate it evenly over five years. Its tax return deducts more at the start. The company earns $50 million a year before depreciation, and the federal corporate tax rate is 21%.2 The depreciation pattern here is hypothetical.
| Year | Depreciation in the statements | Tax expense reported | Depreciation for tax | Tax paid | Deferred tax liability at year end |
|---|---|---|---|---|---|
| 1 | 20 | 6.3 | 40 | 2.1 | 4.2 |
| 2 | 20 | 6.3 | 30 | 4.2 | 6.3 |
| 3 | 20 | 6.3 | 10 | 8.4 | 4.2 |
| 4 | 20 | 6.3 | 10 | 8.4 | 2.1 |
| 5 | 20 | 6.3 | 10 | 8.4 | 0 |
| Total | 100 | 31.5 | 100 | 31.5 |
In the statements, profit before tax is $30 million every year ($50 million less $20 million), so tax expense is $6.3 million every year. On the tax return, year 1's taxable income is only $10 million, so the company pays $2.1 million. The other $4.2 million hasn't been avoided. It's been postponed, and it's recorded as a Deferred tax liability. Tax a company has recorded as an expense but hasn't yet had to pay, usually because tax rules let it take deductions sooner than its financial statements do. Glossary. From year 3 the company pays more than it expenses, and the liability runs down to zero. Over five years the totals match.
For a company that keeps investing, new assets create new postponements as fast as old ones reverse, so the liability can keep growing for decades. It works like an interest-free loan from the government that's repaid only if investment slows. That's why some investors treat a long-standing deferred tax liability as less of a burden than ordinary debt of the same size. It shouldn't be ignored, though, because it does come due when the company stops growing.
The rest of this lesson is for members
Still to come in this lesson: Deferred tax assets, The effective tax rate, What to check, the key takeaways, and 2 quiz questions with explanations.
Membership opens every lesson in the curriculum, the capstone projects, the interactive tools, and the members-only channels in the Hyperion Entities Discord. The first lesson of every module stays free.
Go deeper
- Stock-Based CompensationFinancial Statement Analysis in Depth (depth track)
- Quality of EarningsFinancial Statement Analysis in Depth (depth track)
- Accounting Red FlagsFinancial Statement Analysis in Depth (depth track)
Notes and sources
- Financial Accounting Standards Board. Statement of Financial Accounting Standards No. 109, Accounting for Income Taxes (February 1992, as amended). Checked 2026-10-11. Back to text
- Internal Revenue Service. Publication 542, Corporations. Checked 2026-10-11. Back to text