Permanent and Temporary Differences Between Taxable Income and Accounting Profits

A permanent difference between taxable income and accounting profits results when a revenue (gain) or expense (loss) enters book income but never recognized in taxable income or vice versa. The difference is permanent as it does not reverse in the future. Thus, book and tax will never equalize.

These differences do not result in the creation of a deferred tax. Instead of creating a deferred tax asset or liability, the permanent difference results in a difference between the company’s effective tax rate and the statutory tax rate.

Effective tax rate = Income tax expense/Pre-tax income

Some examples of permanent differences are: Fines and Penalties, Meals and Entertainment, Political Contributions, Officers Life Insurance, and Tax-exempt Interest.

A temporary difference results when a revenue (gain) or expense (loss) enters book income in one period but affects taxable income in a different (earlier or later) period. A temporary difference is expected to reverse in the future and therefore results in the creation of a DTL or DTA. The following are some examples of temporary differences and DTL/DTA created.


Event	Book Income	Tax Income	Def. Tax Asset	Def. Tax Liability
Installment Sales	Revenue Today	Income Later		Yes
Product Warranties	Expense Today	Deduction Later	Yes
Bad Debt Expense	Expense Today	Deduction Later	Yes
Rent Rec’d in Advance	Revenue Later	Income Today	Yes
Depreciation Expense	Straight-Line	Accelerated		Yes
Prepaid Expenses	Expense Later	Deduction Today		Yes
Impairment	Expense Today	Deduction Later	Yes

Note that a Deferred Tax Liability is created when Future Taxable Income > Future Book Income. A Deferred Tax Asset is created when Future Taxable Income < Future Book Income.

The following table summarizes how differences in carrying amount and tax base result in creation of DTL and DTA.

Balance Sheet Item	Carrying Amount Vs. Tax Base	Result
Asset	Carrying Amount > Tax Base	Deferred tax liability
Asset	Carrying Amount < Tax Base	Deferred tax asset
Liability	Carrying Amount > Tax Base	Deferred tax asset
Liability	Carrying Amount < Tax Base	Deferred tax liability

Temporary differences can be of two types:

Taxable temporary differences: These differences result in future taxable income.
Deductible temporary differences: These differences result in future tax deductions.

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Permanent and Temporary Differences Between Taxable Income and Accounting Profits

Example of a Deferred Tax Liability

Valuation Allowance for Deferred Tax Assets

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