Deferred Tax Explained: Temporary vs Permanent Differences (2026)

Deferred Tax Explained: Temporary vs Permanent Differences (2026)

What Is Deferred Tax?

Deferred tax represents taxes payable or recoverable in future periods due to differences between how transactions are treated for accounting purposes versus tax purposes. These differences arise because accounting standards (IFRS, US GAAP) and tax laws often recognize income and expenses at different times.

The accounting for deferred taxation is governed by:

• IFRS: IAS 12 Income Taxes
• US GAAP: ASC 740 Income Taxes

Both frameworks use similar principles: identify temporary differences, compute deferred tax assets/liabilities, and recognize them on the balance sheet. The income tax expense reported on the income statement comprises both current tax (tax payable now) and deferred tax (future tax effects of temporary differences).

Temporary Differences

Temporary differences are differences between the carrying amount of an asset or liability in the financial statements and its tax base. These differences will reverse in future periods as the asset is recovered or the liability is settled.

Taxable Temporary Differences (Deferred Tax Liabilities)

These differences result in taxable amounts in future periods:

• Accelerated depreciation: Tax depreciation exceeds accounting depreciation in early years.
• Capital gains: Recognized in accounting when realized for tax.
• Business combinations: Assets acquired at fair value higher than tax base.
• Revaluation: Asset values increased for accounting but tax base unchanged.

Deductible Temporary Differences (Deferred Tax Assets)

These differences result in deductible amounts in future periods:

• Warranty provisions: Expensed in accounts when sold but deductible when paid.
• Bad debt provisions: Recognized in accounting before tax deduction allowed.
• Share-based payments: Expensed over vesting period but deductible on exercise.
• Tax loss carryforwards: Losses available to offset future taxable profit.

Permanent Differences

Permanent differences are items that affect either accounting profit or taxable profit but never both. They do not reverse.

Deferred Tax Assets (DTA)

A deferred tax asset represents future tax benefits. DTAs arise from:

• Deductible temporary differences
• Unused tax losses
• Unused tax credits

Valuation Allowance

Under US GAAP, DTAs are recognized to the extent that realization is "more likely than not." If not, a valuation allowance reduces the DTA. IFRS uses a similar "probable" threshold.

Deferred Tax Liabilities (DTL)

A deferred tax liability represents future tax obligations. DTLs arise from:

• Taxable temporary differences
• Taxable profit timing differences

Recognition Exceptions

• Goodwill: DTL not recognized on initial recognition of goodwill.
• Initial recognition exemption: Certain asset/liability differences exempt.
• Investments in subsidiaries: DTL only if distribution is probable.

Measurement

Deferred taxes are measured using:

• Tax rates: Enacted or substantively enacted rates expected to apply when the temporary difference reverses.
• Not discounted: Deferred taxes are not discounted to present value, even if reversal is many years away.
• Reassessment: Reviewed at each reporting date; changes in tax rates affect the income statement in the period enacted.

Practical Examples with Journal Entries

Example 1: Depreciation Timing Difference (Creates DTL)

A company purchases equipment for $100,000. For accounting, straight-line depreciation over 5 years ($20,000/year). For tax, the asset qualifies for immediate expensing under bonus depreciation rules.

Year 1:

• Accounting depreciation: $20,000
• Tax depreciation: $100,000
• Temporary difference: $80,000 (will reverse in Years 2-5)
• At 25% tax rate: DTL = $20,000

Dr. Income Tax Expense (deferred)    $20,000
    Cr. Deferred Tax Liability               $20,000
(To recognize deferred tax on timing difference)

Year 2 (when timing difference begins reversing):

Dr. Deferred Tax Liability    $5,000
    Cr. Income Tax Expense (deferred)    $5,000
(To reverse portion of DTL as temp. difference reverses)

Example 2: Warranty Provision (Creates DTA)

A company sells products with a 12-month warranty. In Year 1, it estimates $50,000 in warranty claims and records the expense. Tax rules only allow deduction when claims are actually paid (in Year 2).

Year 1:

• Accounting expense: $50,000
• Tax deduction: $0
• Temporary difference: $50,000 (deductible)
• At 25% tax rate: DTA = $12,500

Dr. Deferred Tax Asset              $12,500
    Cr. Income Tax Expense (deferred)    $12,500
(To recognize deferred tax asset on warranty provision)

Year 2 (when warranty claims are paid):

Dr. Income Tax Expense (deferred)    $12,500
    Cr. Deferred Tax Asset                   $12,500
(To reverse DTA as warranty expense becomes tax deductible)

Example 3: Permanent Difference (No Deferred Tax Impact)

A company pays $10,000 in fines for regulatory violations. Fines are expensed for accounting purposes but are never deductible for tax — this is a permanent difference.

Result: No deferred tax is created. The $10,000 reduces accounting profit but never reduces taxable profit. This increases the effective tax rate compared to the statutory rate.

Temporary vs Permanent: Quick Reference

IFRS vs US GAAP: Key Differences

Common Pitfalls in Practice

• Ignoring the reversing pattern: Temporary differences must be tracked by year of expected reversal for proper rate application.
• Missing valuation allowance assessment: DTAs must be tested for realizability every period. Don't assume future profits.
• Confusing temporary and permanent: Review differences carefully — some items that appear permanent (like some equity adjustments) may actually be temporary.
• Rate changes: When tax rates change, deferred tax balances must be remeasured — this often creates significant income statement volatility.
• Outside basis differences: Investments in subsidiaries can create deferred tax liabilities that are often overlooked.

Related Resources

Last updated: February 14, 2026