Question

Explain the difference between temporary and permanent differences and provide an example of each.

Answer 1

Solution:-

What are permanent/temporary differences in tax accounting:-

The difference in accounting for taxes between financial statements and tax returns creates a permanent and temporary difference in tax expenses on the income statement. The financial statements will arrive at a tax expense, but the actual tax payable will come from the tax return. This guide will explore the impact of these permanent and temporary differences in tax accounting.

What is a permanent difference in tax expense:-

A permanent difference is a difference between the tax expense and tax payable caused by an item that does not reverse over time. In other words, it is a 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 of temporary differences.

What is a temporary difference in tax expense:-

Temporary differences are differences between pretax book income and taxable income that will eventually reverse itself or be eliminated. To put this another way, 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.

An example of a timing difference is rent income. Accrual accounting will only allow revenue to be recorded when it is earned, but if a company receives an advanced payment of rental income, it must report this under taxable income on its tax return. As such, this revenue will be recorded on the tax return but not the book income. This creates a timing difference in this period. At a future period when the rental revenue is finally earned, the company will record that revenue under book income but not on its tax return, thereby reversing and eliminating the initial difference.

What effect do these differences have in tax accounting:-

A permanent difference will never be reversed, and as such, will only have an impact in the period it occurs. Often, the only impact is that the effective tax rate on the books will be higher or lower than the effective tax rate on the company’s tax return.

A temporary difference, however, creates a more complex effect on a company’s accounting. If a temporary difference causes pre-tax book income to be higher than actual taxable income, then a deferred tax liability is created. This is because the company has now earned more revenue in its book than it has recorded on its tax returns. The company knows that this will eventually have to reverse, and the company will have higher returns and thus higher taxes on its tax returns at a future period. Transitively, having lower book income than tax income will result in the creation of a deferred tax asset.