IAS 12 Deferred Tax: Temporary vs Permanent Differences With Worked Example

A client's tax computation shows €1.2M of entertainment expenses disallowed for tax. No deferred tax entry. Correct. The same computation shows €400,000 of accelerated depreciation with no deferred tax entry. That's wrong. The distinction between permanent and temporary differences is the single concept that separates a defensible deferred tax balance from one that falls apart under review.

Under IAS 12, a deferred tax asset or liability arises from temporary differences (the difference between an asset's or liability's carrying amount and its tax base), which create taxable or deductible amounts in future periods. Permanent differences (items never taxable or deductible) generate no deferred tax (IAS 12.5, IAS 12.15). The auditor's job is to verify that management has correctly classified each difference and applied the enacted or substantively enacted tax rate under IAS 12.47.

Table of contents

1. Temporary versus permanent differences: the IAS 12.5 framework
2. Recognising deferred tax liabilities under IAS 12.15-18
3. Recognising deferred tax assets under IAS 12.24-28
4. Rate changes and their effect on deferred tax (IAS 12.47)
5. Tax loss carryforwards: the DTA recoverability problem
6. Disclosure requirements under IAS 12.81
7. Worked example: Müller Fertigung GmbH
8. Practical checklist
9. Common mistakes
10. Related content

For a structured calculation tool that walks through each category of temporary difference and computes the deferred tax balance, the ciferi IAS 12 deferred tax calculator is built for audit engagements. It separates temporary from permanent differences, applies the correct rate, and flags DTA recoverability issues.

Temporary versus permanent differences: the IAS 12.5 framework

IAS 12.5 defines a temporary difference as the difference between the carrying amount of an asset or liability in the statement of financial position and its tax base. The tax base of an asset is the amount that will be deductible for tax purposes against any taxable economic benefits that will flow to the entity when it recovers the carrying amount (IAS 12.7). The tax base of a liability is its carrying amount minus any amounts deductible for tax purposes in future periods (IAS 12.8).

Temporary differences reverse. That's the defining characteristic. An asset with a carrying amount of €500,000 and a tax base of €350,000 has a taxable temporary difference of €150,000. When the asset's carrying amount is recovered (through use or sale), the entity will recognise taxable income of €150,000 more than the tax deduction available. A deferred tax liability arises.

Permanent differences never reverse. Entertainment expenses disallowed for tax purposes have no future tax consequence. The carrying amount of the asset (cash spent) and the tax base are identical (zero deduction now, zero deduction later). No temporary difference exists. No deferred tax arises.

The practical classification test is straightforward: will this item affect taxable profit in a future period? If yes, it's temporary. If no, it's permanent. Common temporary differences include accelerated depreciation, fair value remeasurements of investment property, provisions recognised for accounting purposes but deductible only when paid, and unrealised gains on financial instruments. Common permanent differences include entertainment expenses, fines and penalties, non-deductible goodwill amortisation (in jurisdictions that disallow it), and tax-exempt income (such as participation exemptions on qualifying dividends).

A grey area exists where the classification depends on management's intention. IAS 12.51 requires the entity to consider the manner in which it expects to recover the carrying amount of an asset when measuring deferred tax. An investment property that will be sold (capital gain, potentially at a different rate) produces a different deferred tax balance than one that will be held and depreciated (ordinary income reversal). If management changes its intention (from hold to sell), the deferred tax must be remeasured. Auditors should document management's stated intention, assess its consistency with other evidence (board minutes, marketing of the property, capital allocation plans), and evaluate whether the tax rate applied matches the intended recovery method.

Recognising deferred tax liabilities under IAS 12.15-18

IAS 12.15 sets the default: recognise a deferred tax liability for all taxable temporary differences. The exceptions in IAS 12.15 are narrow. You do not recognise a DTL arising from the initial recognition of goodwill (IAS 12.15(a)). You do not recognise a DTL arising from the initial recognition of an asset or liability in a transaction that is not a business combination and, at the time of the transaction, affects neither accounting profit nor taxable profit (the initial recognition exemption in IAS 12.15(b)).

Outside those exceptions, every taxable temporary difference produces a DTL. The calculation is the temporary difference multiplied by the tax rate that is expected to apply when the difference reverses (IAS 12.47). Use the enacted or substantively enacted rate at the reporting date.

For auditors, the risk on DTLs is understatement. Management has an incentive to minimise DTLs because they reduce net assets. Check that all taxable temporary differences have been identified. The most commonly missed are fair value uplifts on property, plant and equipment recognised in a business combination (the DTL should be recognised on the difference between fair value and tax base), revaluations of investment property, and capitalised development costs where tax relief was claimed immediately.

Recognising deferred tax assets under IAS 12.24-28

IAS 12.24 requires recognition of a deferred tax asset for all deductible temporary differences to the extent that it is probable that taxable profit will be available against which the deductible temporary difference can be utilised. The probability test is the key audit judgment.

"Probable" in IFRS means more likely than not (greater than 50%). The entity must demonstrate that it will generate sufficient taxable profit in future periods to absorb the deductible amount. IAS 12.28 lists factors to consider: whether the entity has sufficient taxable temporary differences relating to the same taxation authority and the same taxable entity that will result in taxable amounts in the periods the DTA is expected to reverse, whether it is probable that the entity will have taxable profit before the DTA expires, and whether the deductible temporary differences result from identifiable causes that are unlikely to recur.

The audit risk on DTAs is overstatement. Management wants to recognise DTAs because they increase net assets. The larger the DTA, the better the balance sheet looks. For entities with a history of losses, the recoverability test is the most judgment-heavy area on the engagement. If the entity has accumulated losses for the past two or more years, IAS 12.35 creates a rebuttable presumption that future taxable profit will not be available. Management must provide convincing evidence to overcome this presumption.

Auditors should compare management's profit projections (used to support DTA recoverability) to the projections used for impairment testing (IAS 36) and going concern (ISA 570). If management projects taxable profits of €2M per year for DTA recoverability but the going concern assessment shows the entity barely breaking even, the inconsistency needs resolution. The ciferi IAS 12 deferred tax calculator includes a recoverability module that compares DTA utilisation schedules to forecast taxable income.

Rate changes and their effect on deferred tax (IAS 12.47)

IAS 12.47 requires deferred tax to be measured at the tax rate expected to apply in the period the asset is realised or the liability is settled, based on rates enacted or substantively enacted at the reporting date. When a government announces a rate change, the deferred tax balance must be remeasured using the new rate.

The effect flows through profit or loss (IAS 12.60) unless the deferred tax relates to items recognised outside profit or loss (in other comprehensive income or directly in equity). For a DTL of €300,000 computed at 25%, a rate reduction to 22% reduces the DTL to €264,000. The €36,000 credit goes to the income tax line in profit or loss.

Rate changes create audit work because they affect every open temporary difference simultaneously. The entire deferred tax schedule must be remeasured, not just the items originating in the current year. For Dutch entities, the corporate income tax rate structure (15% on the first €200,000, 25.8% above that threshold) means auditors must assess which rate applies to each temporary difference based on the expected level of taxable profit in the reversal period.

The timing of "substantive enactment" varies by jurisdiction. In the Netherlands, a rate change is substantively enacted when the bill passes the Tweede Kamer (House of Representatives), even if the Eerste Kamer (Senate) has not yet approved it. In Germany, substantive enactment requires approval by the Bundestag and Bundesrat. The auditor must confirm the legislative status at the reporting date and apply only rates that have passed the substantive enactment threshold. A rate change announced in the government's coalition agreement but not yet introduced as legislation does not qualify.

For entities with deferred tax balances that reverse over multiple years, a scheduled rate change (where the rate changes in Year 1 and again in Year 3) requires the auditor to match each temporary difference to its expected reversal year and apply the rate in effect for that year. A blanket application of the current rate to all temporary differences is wrong when a phased rate change is in progress.

Tax loss carryforwards: the DTA recoverability problem

Tax losses available for carryforward create a potential DTA under IAS 12.34. The recognition test is the same as for other deductible temporary differences: probable taxable profit must be available. But for entities with tax losses, the burden of proof is heavier because the very existence of the losses indicates a history of unprofitability.

The Netherlands limits carryforward of tax losses to six years for losses arising after 1 January 2022 (with an unlimited carryforward for the first €1M). Germany allows unlimited carryforward but restricts annual utilisation to €1M plus 60% of the excess. These jurisdictional rules affect how quickly the DTA can be utilised and therefore whether recognition is appropriate.

Audit procedures on tax loss carryforwards include confirming the loss amounts to tax assessments or filed returns, verifying the expiry dates under local tax law, comparing forecast taxable profits to historical results, and checking whether the forecasts are consistent with projections used elsewhere in the file (impairment models, going concern assessments, budget approvals).

If the entity has losses in the current year and the prior year, the bar for recognising a DTA on carryforward losses is high. Management's projection of "we'll return to profit next year" needs support from specific, verifiable changes in circumstances. A new contract, a completed restructuring, a closed loss-making division. General optimism does not satisfy IAS 12.35.

Disclosure requirements under IAS 12.81

IAS 12.81 requires disclosure of the major components of tax expense (current tax, deferred tax, rate change effects, previously unrecognised tax losses now recognised), a reconciliation between the effective tax rate and the applicable tax rate, the amount of deductible temporary differences and unused tax losses for which no DTA has been recognised, and the aggregate amount of temporary differences associated with investments in subsidiaries for which no DTL has been recognised.

The effective tax rate reconciliation is where reviewers spend the most time. Each reconciling item should be identified by nature (permanent differences, rate differences, prior-year adjustments, rate changes, unrecognised DTAs). If the reconciliation contains a large "other" line with no explanation, the disclosure fails IAS 12.81(c).

For audit purposes, the reconciliation serves as a reasonableness check on the total tax charge. If the entity's applicable rate is 25.8% and the effective rate is 18%, you need to identify which reconciling items account for the 7.8% difference and verify each one. A large unexplained deviation between applicable and effective rates is an indicator that deferred tax has been misstated.

The reconciliation also serves as a fraud indicator. An entity that consistently reports an effective tax rate well below the statutory rate without transparent reconciling items may be understating its tax liability. Compare the ETR to industry peers and to the entity's own historical ETR. A sudden drop without a corresponding change in the business (no new tax incentive, no rate change, no change in geographic mix) warrants investigation.

IAS 12.81(g) requires disclosure of the amount of deductible temporary differences, unused tax losses, and unused tax credits for which no deferred tax asset has been recognised. This disclosure is frequently incomplete. Auditors should verify that the unrecognised amount reconciles to the entity's tax loss records and that the reasons for non-recognition are consistent with the recoverability assessment performed for recognised DTAs. If the entity recognises a DTA on €600,000 of losses but does not disclose €200,000 of additional losses for which no DTA was recognised, the disclosure is incomplete.

Worked example: Müller Fertigung GmbH

Müller Fertigung GmbH is a German manufacturing company with €35M revenue and pre-tax profit of €2.8M. The applicable corporate income tax rate (including trade tax and solidarity surcharge) is 30%. The entity has four items requiring deferred tax analysis.

1. The entity owns a CNC machine with a carrying amount of €1,200,000 and a tax base of €900,000 (tax depreciation is accelerated). Temporary difference: €300,000 (taxable). Deferred tax liability: €300,000 x 30% = €90,000.

   Documentation note: "Taxable temporary difference on CNC machine. Carrying amount €1,200K per fixed asset register (agreed to FA lead). Tax base €900K per tax depreciation schedule (agreed to filed Steuererklärung 2024). DTL recognised at €90K. Difference will reverse over remaining useful life as accounting depreciation exceeds tax depreciation."

2. The entity has a warranty provision of €180,000 recognised under IAS 37. The provision is not deductible until claims are paid. Tax base of the liability: €180,000 (carrying amount) minus €180,000 (future deduction) = €0. Temporary difference: €180,000 (deductible). Deferred tax asset: €180,000 x 30% = €54,000.

   Documentation note: "Deductible temporary difference on warranty provision. Carrying amount €180K per provisions schedule. Tax deduction available on payment (confirmed with tax adviser, reference to §5 Abs. 3 EStG). DTA of €54K recognised. Entity profitable in current and prior four years (recoverability supported by forecast taxable income of €2.5M+ p.a.)."

3. The entity incurred €45,000 in entertainment expenses, fully disallowed for tax. This is a permanent difference. No deferred tax arises.

   Documentation note: "Permanent difference: entertainment expenses of €45K non-deductible per §4 Abs. 5 Nr. 2 EStG. No temporary difference. No DTA/DTL. Included in ETR reconciliation as permanent item increasing effective rate."

4. The entity has unused tax losses of €600,000 carried forward from 2023. Management projects taxable profit of at least €2.5M for 2026. Under German Mindestbesteuerung rules, the entity can offset €1M plus 60% of profits above €1M. With projected profit of €2.5M, the available offset is €1M + 60% x €1.5M = €1.9M. The €600,000 loss can be fully utilised in one year. DTA: €600,000 x 30% = €180,000.

   Documentation note: "Tax loss carryforward of €600K per Feststellungsbescheid 2024 (tax loss assessment notice received 12 March 2025). Utilisation feasible within one year given projected taxable profit of €2.5M and Mindestbesteuerung cap of €1.9M. Forecast profit compared to 2024 actual of €2.8M and 2023 actual of €2.4M (loss year was 2023 H1 only, due to one-time plant closure costs). DTA of €180K recognised."

The deferred tax balance for Müller Fertigung GmbH: DTL of €90,000, DTA of €54,000 + €180,000 = €234,000. Net DTA of €144,000. The ETR reconciliation shows the 30% applicable rate adjusted for the permanent entertainment difference (€45K x 30% / €2.8M PBT = +0.5%) and utilisation of prior-year losses (€600K x 30% / €2.8M = -6.4%), producing an effective rate of approximately 24.1%.

Practical checklist

1. Obtain management's schedule of all temporary and permanent differences. Verify each item is correctly classified by applying the IAS 12.5 test: does the difference between carrying amount and tax base reverse in a future period?

2. For DTAs, test recoverability by comparing management's forecast taxable profits to historical results. Cross-check to projections used in impairment (IAS 36) and going concern (ISA 570) work. Inconsistencies between these forecasts need resolution.

3. Verify the tax rate applied is the enacted or substantively enacted rate at the reporting date (IAS 12.47). For jurisdictions with tiered rates (Netherlands, for example), confirm the rate used matches the expected level of taxable profit in the reversal period.

4. For tax loss carryforwards, confirm the loss amount and expiry date to tax assessments or filed returns. Verify that jurisdictional utilisation limits (Germany's Mindestbesteuerung, the Netherlands' six-year cap) have been applied.

5. Review the ETR reconciliation for completeness. Each reconciling item above 1% of PBT should be separately identified. A large "other" balance indicates missing analysis.

Common mistakes

• Recognising a DTA on tax losses without testing recoverability against specific profit forecasts. The FRC has flagged files where DTAs were recognised on €2M+ of accumulated losses with no evidence of probable future taxable profit beyond a generic statement that "management expects to return to profitability."

• Missing temporary differences on business combination fair value uplifts. When the acquirer recognises an asset at fair value (€5M) but the tax base remains at the predecessor's cost (€3M), a €2M taxable temporary difference exists. The DTL is often omitted from the purchase price allocation because the tax adviser was not involved in the fair value exercise.

• Applying the wrong rate to temporary differences expected to reverse in periods with different tax rates. For Dutch entities, applying 25.8% to all temporary differences ignores the 15% rate on the first €200,000 of taxable profit, which may apply if the entity is small or the difference reverses in a loss year.

Related content

• Deferred tax glossary entry. Covers the IAS 12 definitions of temporary differences, tax base, and the recognition criteria for DTAs and DTLs.
• IAS 12 deferred tax calculator. The calculator referenced in this post, with separate modules for temporary difference identification, DTA recoverability testing, and ETR reconciliation.
• IAS 36 impairment testing: calculating value in use step by step. Relevant because auditors must cross-check profit projections used for DTA recoverability to those used for impairment.