Income Tax Accounting: Temporary vs. Permanent Differences
- Graziano Stefanelli
- Jun 24
- 3 min read
1. Introduction
Income tax accounting requires companies to reconcile the differences between accounting income (reported in financial statements) and taxable income (used to calculate income tax payable). A critical part of this process involves understanding the distinction between temporary differences and permanent differences, which directly impacts the recognition of deferred tax assets and liabilities under both US GAAP and IFRS. nancial reporting and tax compliance.
2. Accounting Income vs. Taxable Income
Accounting income is calculated based on accounting standards (US GAAP or IFRS), while taxable income follows the rules of the tax authorities in the relevant jurisdiction. These two measures of income can differ due to varying rules about when to recognize revenue and expenses, resulting in the need for careful reconciliation at every period-end.
3. What Are Temporary Differences?
Temporary differences are differences between the carrying amount of an asset or liability in the financial statements and its tax base, which will result in taxable or deductible amounts in future years when the asset is recovered or the liability is settled.
Key Characteristics:
Reverse over time (eventually eliminated).
Result in deferred tax assets (DTAs) or deferred tax liabilities (DTLs).
Examples:
Depreciation: Accelerated depreciation for tax, straight-line for accounting.
Accrued expenses: Deducted for accounting when incurred, but for tax when paid.
Unearned revenue: Taxed when received, recognized in accounting when earned.
4. What Are Permanent Differences?
Permanent differences are items of income or expense that are recognized either in the financial statements or on the tax return, but never in both. These differences do not reverse over time and therefore do not create deferred tax balances.
Key Characteristics:
Do not reverse; remain as differences permanently.
Do not give rise to deferred tax assets or liabilities.
Examples:
Fines and penalties: Deducted in accounting, never deductible for tax.
Tax-exempt interest income: Recognized in accounting income, never taxed.
Life insurance proceeds: Income in accounting, not taxable.
5. How Temporary Differences Create Deferred Taxes
Temporary differences that will result in future deductible amounts create deferred tax assets, while those resulting in future taxable amounts create deferred tax liabilities.
Example:
A company reports more depreciation for tax purposes in the early years of an asset, creating a lower taxable income than accounting income (DTL created). Over time, as depreciation reverses, this difference is eliminated.
6. Examples of Temporary Differences
Warranty expenses: Deducted for accounting when estimated, for tax when paid (DTA).
Bad debt expense: Allowance method for accounting, direct write-off for tax (DTA).
Prepaid expenses: Deducted for tax when paid, for accounting when consumed (DTL).
Installment sales: Revenue for accounting when earned, for tax when cash is received (DTL).
7. Examples of Permanent Differences
Municipal bond interest: Recorded as income for financial reporting, exempt for tax.
Non-deductible expenses: Political contributions, fines.
Dividends received deduction: Partially or fully deductible for tax but recognized for accounting.
8. Journal Entry Examples
For a Temporary Difference (Deferred Tax Liability):
Suppose tax depreciation exceeds book depreciation by $5,000 at a 30% tax rate.
Dr. Income Tax Expense ..................... $1,500
Cr. Deferred Tax Liability .................... $1,500
For a Permanent Difference:
No journal entry for deferred taxes; only the current tax effect is recognized.
9. Reporting in the Financial Statements
Deferred tax assets and deferred tax liabilities are reported as noncurrent items on the balance sheet.
Permanent differences affect only the current period’s effective tax rate, with no balance sheet impact.
Disclosures must clearly describe the sources of significant temporary and permanent differences.
10. Effect on the Effective Tax Rate
Permanent differences cause the company’s effective tax rate to differ from the statutory tax rate. A reconciliation of these differences is required in the notes to the financial statements.
Example Table:
Item | Amount | Tax Effect |
Statutory Tax Rate | — | 27% |
Municipal Bond Interest | (10,000) | - |
Non-deductible Fines | 5,000 | + |
Effective Tax Rate | — | 25% |
11. US GAAP and IFRS References
US GAAP: ASC 740 – Income Taxes
IFRS: IAS 12 – Income Taxes
Both frameworks require the recognition of deferred tax assets and liabilities for temporary differences, but not for permanent differences.
12. Summary Table: Temporary vs. Permanent Differences
Type | Examples | Deferred Tax? | Reverses? |
Temporary Difference | Depreciation, accruals | Yes (DTA/DTL) | Yes |
Permanent Difference | Fines, tax-exempt income | No | No |
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