The basic principle of accounting for deferred tax under a temporary difference approach can be illustrated using a common

example in which a company has fixed assets which qualify for tax depreciation. The following example assumes that a company purchases an asset for $1,000 which is depreciated for accounting purposes on a straight-line basis of five years. The company claims tax depreciation of 25% per year. The applicable rate of corporate income tax is assumed to be 35%. And then subtract the net value. Purchase Accounting value Tax value Taxable/(deductible) temporary difference Deferred tax liability/(asset) at 35% Year 1 Year 2 Year 3 Year 4 $1,000 $800 $1,000 $750 $0 $0 $50 $18 $600 $563 $37 $13 $400 $422 $(22) $(8) $200 $316 $(116) $(41)

As the tax value, or tax base, is lower than the accounting value, or book value, in years 1 and 2, the company should recognize a deferred tax liability. This also reflects the fact that the company has claimed tax depreciation in excess of the expense for accounting depreciation recorded in its accounts, whereas in the future the company should claim less tax depreciation in total than accounting depreciation in its accounts. In years 3 and 4, the tax value exceeds the accounting value, therefore the company should recognise a deferred tax asset (subject to it having sufficient forecast profits so that it is able to utilise future tax deductions). This reflects the fact that the company expects to be able to claim tax depreciation in the future in excess of accounting depreciation.