Deferred tax is the very important topic in financial accounting. It arises due to differences in tax profit and accounting profit. There are two main reasons for such differences:
This difference arises when an item of expense is not an allowable expense in tax. As a result, the different remains permanent and in future, there is no chance that this expense will revert. In order to arrive at the taxable profit, such expense is added back to the accounting profit.
Sometimes it happens that an item of expense is allowed for tax purposes but at a different rate. This results in lower expense charge in initial years as compared to the accounting treatment. This is quite common for depreciation rate in tax purposes. Usually, accounting basis uses a lower rate to depreciate the asset, while tax base uses a higher rate of depreciation. As a result, the profits of various periods differ due to different depreciation expense in tax and accounting. However, after the passage of years, this difference eliminates and gets equal to zero. That is why we call it temporary difference.