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.

EventBook IncomeTax IncomeDef. Tax AssetDef. Tax Liability
Installment SalesRevenue TodayIncome LaterYes
Product WarrantiesExpense TodayDeduction LaterYes
Bad Debt ExpenseExpense TodayDeduction LaterYes
Rent Rec’d in AdvanceRevenue LaterIncome TodayYes
Depreciation ExpenseStraight-LineAcceleratedYes
Prepaid ExpensesExpense LaterDeduction TodayYes
ImpairmentExpense TodayDeduction LaterYes

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 ItemCarrying Amount Vs. Tax BaseResult
AssetCarrying Amount > Tax BaseDeferred tax liability
AssetCarrying Amount < Tax BaseDeferred tax asset
LiabilityCarrying Amount > Tax BaseDeferred tax asset
LiabilityCarrying Amount < Tax BaseDeferred 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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