Why do you calculate deffered tax?

When we prepare a set of financial statements we use a whole raft of accounting policies that (are supposed to!) result in a profit or loss figure that gives a true and fair view of the performance of the company for that year.

Then we have to calculate a different profit for the tax man - one based not on the policies that best fit our company, but on tax laws designed to make the system more uniform and less prone to, shall we say, the vagaries of opinion.

Most commonly (in the UK at least) this means that depreciation is disallowed and instead we are given Capital Allowances in their place. The two figures will rarely match.

Where this means that the profit we declare in the P&L is higher than the profit we will be paying tax on, we have to charge what is called Deferred Tax.

This is an application of the matching (or accruals) and prudence concepts. In the long term the two profits (declared in the P&L and charged to tax) will be equal. If we think we've made more profit than we have been taxed on so far then it is both prudent and proper* to recognise a charge (or credit - remember the effect is cumulative and Deferred Tax is shown as a liability in the Balance Sheet) in this years accounts for the tax we know is eventually going to have to be paid.

*Proper because we think that the tax charge we will incur in the future actually belongs to profits we made now - this is the accruals concept.