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(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 companys
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
Installment Sales
Product Warranties
Bad Debt Expense
Rent Recd in
Advance
Depreciation Expense
Prepaid Expenses
Impairment
Revenue Today
Expense Today
Expense Today
Income Later
Deduction Later
Deduction Later
Yes
Yes
Yes
Revenue Later
Income Today
Yes
Straight-Line
Expense Later
Expense Today
Accelerated
Deduction Today
Deduction Later
Yes
Yes
Yes
Def. Tax
Liability
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
Asset
Asset
Liability
Liability
Result
Deferred tax liability
Deferred tax asset
Deferred tax asset
Deferred tax liability
because of a transaction that took place during the current period, such as an installment sale
receivable.
A Deferred Tax Asset is an asset on a companys balance sheet that may be used to reduce
taxable income. It is the opposite of a deferred tax liability, which describes something that will
increase income tax. Both are found on the balance sheet under Current Assets.
When recorded income taxes payable are higher than the income taxes paid to the government, a
deferred tax asset is created.
Some of the top reasons why tax assets are needed include:
Revenues are recognized in one period for tax purposes and in a different period for
accounting purposes.
Some assets have a different tax base for governmental agencies compared to accounting
practices.
The company paid too much tax, and deserves some money returned.
Losses or expenses are recognized in the income statement before they are recognized by
the respective tax authority.
Blue Print Inc, a manufacturing printer company, uses the IFRS accounting principle.
They recognize $10 million in revenue and $9 million in expenses, leaving them with $1 million
of profit. From the $9 million in expenses, $8 million are from cost of goods sold and $1 million
from probable future warranties and returns expenses. Because tax authorities usually do not
allow companies to deduct expenses based on future costs, Blue Print Inc is required to pay taxes
based on a profit of $2 million ($10 million - $8 million) without taking into account the $1
million in warranties. The difference of the amount paid in taxes to the government and the
amount recorded in the financial statements is considered a deferred tax asset.
Temporary Difference
Definition: A temporary difference is the difference between the carrying amount of an asset or
liability in the balance sheet and its tax base. A temporary difference can be either of the
following:
Deductible. A deductible temporary difference is a temporary difference that will yield amounts
that can be deducted in the future when determining taxable profit or loss.
Taxable. A taxable temporary difference is a temporary difference that will yield taxable
amounts in the future when determining taxable profit or loss.
In both cases, the differences are settled when the carrying amount of the asset or liability is
recovered or settled.
Because of temporary differences, the expense that an entity incurs in a reporting period usually
comprises both current tax expense or income, and deferred tax expense or income.
Tax differential: