Tax expense of 250, cash paid of 170
An income statement may show tax expense of 250 while the cash flow statement shows only 170 actually paid that year. Neither is wrong; the two numbers answer different questions. Tax expense is the tax that corresponds to this year's accounting profit. Cash paid is the money that actually went to the tax authority this year.
This guide explains why the two diverge, splitting the difference into current tax, deferred tax, and payment timing, and shows it with a hypothetical calculation. It also explains how to find one-off items in the effective tax rate reconciliation and what to check in the notes and cash flow statement.
Accounting profit versus taxable income
Accounting standards and tax law recognize revenue and expenses at different times and in different ways. If tax law allows extra depreciation in the first year of an equipment purchase, taxable profit falls below accounting profit and this year's tax bill shrinks. Less depreciation will be allowed later, though, so more tax is due in the future.
IAS 12 treats such differences as temporary differences and requires tax payable in the future to be recorded as a deferred tax liability, and tax saved in the future as a deferred tax asset. Tax expense is therefore current tax for the year plus the change in deferred tax.
A hypothetical tax calculation
The table assumes a company with pretax profit of 1,000 and a 25% statutory rate whose taxable income is reduced by 200 through accelerated tax depreciation. Part of last year's tax is settled this year, and part of this year's tax is paid next year.
| Item | Amount | Explanation |
|---|---|---|
| Pretax profit (accounting) | 1,000 | Per the income statement |
| Accelerated depreciation difference | −200 | Larger deduction for tax |
| Taxable income | 800 | Per the tax return |
| Current tax (800 × 25%) | 200 | Tax for this year |
| Deferred tax expense (200 × 25%) | 50 | Tax payable in the future |
| Total tax expense | 250 | Effective rate 25% |
| Cash taxes paid | 170 | Includes last year's settlement; part of this year's is paid next year |
Of the 250 in tax expense, 50 is future tax not yet owed, and the 170 in cash reflects the payment schedule.
Reading the rate reconciliation
The effective tax rate reconciliation in the notes starts from tax at the statutory rate and shows which items bridge to actual tax expense. Typical items include different rates on foreign subsidiaries, expenses not deductible for tax, tax credits, and changes in the valuation of deferred tax assets.
If the company in the table received a research tax credit of 30, tax expense would be 220 and the effective rate 22%. It matters whether the lower rate comes from a credit that can recur each year or a one-time benefit. Carrying a rate lowered by a one-off benefit into future estimates can overstate earnings.
When deferred taxes build up
A company that keeps increasing capital spending generates new accelerated depreciation every year, so its deferred tax liability may keep growing and cash taxes may stay below tax expense for a long time. If investment slows, taxes deferred in the past start to come due and cash paid can exceed expense.
A deferred tax asset is a right to pay less tax in the future, but it can be used only if there is enough future taxable income. A company with continuing losses may write down or not recognize such assets, and that change can move tax expense sharply.
Reading the filings
Tax figures are spread across the income statement, cash flow statement, and notes. Gather them in this order; for U.S. companies, annual reports are on SEC EDGAR.
- Calculate the effective tax rate from tax expense and pretax profit on the income statement.
- Find the split of tax expense into current and deferred tax in the notes.
- Find cash taxes paid in the cash flow statement or notes and compare with the expense.
- Identify the items in the rate reconciliation that move the rate away from statutory, and judge whether they will recur.
- Check the main sources of deferred tax assets and liabilities and any valuation changes.
Looking again on a cash basis
When valuing a business on cash flows, cash taxes paid may matter more than tax expense. A single year's payments can swing with schedules and refunds, though, so look at several years together with the trend in deferred taxes.
When there are tax audits or disputes over interpretation, companies may record a separate liability for uncertain tax positions. Checking the size and movement of such items in the notes helps gauge the risk of future cash outflows.
A simple habit is to put tax expense, current tax, and cash paid side by side for five years. A persistent gap in one direction usually has a structural cause, such as heavy investment, that the notes will explain.
What was simplified
The amounts and rates here are hypothetical. Real companies face different rates and rules in many countries, and tax law changes can force deferred taxes to be remeasured.
When looking at a real company, check IAS 12 and its latest annual report, checking how recent each one is. None of the figures here are a signal to buy or sell.