Question

In the income tax accounting, compare and contrast temporary and permanent differences.

b) Give three examples of each difference

Answer 1

What is a permanent Difference:

A permanent difference is the difference between the tax expense and tax payable because of an item that does not reverse over time.

it is the difference between financial accounting and tax accounting that is never eliminated. An example of a permanent difference is a company incurring a fine. Tax codes rarely ever allow a deduction in the event of a fine, but fines are often deducted from income in book accounting.

A permanent difference will cause a difference between the statutory tax rate and the effective tax rate. Also, because the permanent difference will never be eliminated, this tax difference does not generate deferred taxes, as in the case with temporary differences.

What is Temporary Difference?

Temporary differences are differences between pretax book income and taxable income that will eventually reverse itself or be eliminated over a period of time

Transactions that create temporary differences are recognized by both financial accounting and accounting for tax purposes, but are recognized at different times. This is why temporary differences are also known as timing differences.

Examples of Temporary Differences and permanent Differences

Temporary Differences

• Interest received in advance: Any difference between the carrying amount and tax base is a temporary difference which will reverse in the future.
• Research and development costs: Any difference between the carrying amount and tax base is a temporary difference which will reverse in the future.
• Accounts receivable: Like the case of research and development costs, any difference between the carrying amount and tax base is a temporary difference which will reverse in the future.
• Examples of Permanent Difference
• Expenses for meals and entertainment. The IRS generally allows only a 50 percent deduction for these expenses, while the financial statements record 100 percent of the expenses.
• Dividends receivable: Dividends receivable are not usually taxable, and therefore, the carrying amount will equal to the tax base. This gives rise to a permanent difference and will not result in the recognition of any deferred tax asset or liability. Unlike a temporary difference, a permanent difference will never be reversed. Taxable income and accounting profit will be permanently different with the amount of dividends receivable, even on future financial statements as an effect on the retained earnings reflected on the balance sheet.
• Donations: If tax legislation does not allow donations to be deducted for tax purposes, then no temporary difference will result, and therefore no deferred tax asset or liability will be recognized. This constitutes a permanent difference.