Numerous items create differences between accounting profit and taxable income. These differences can be divided into two types. Show
Permanent differences do not cause deferred tax liabilities or assets. These occur if a revenue or expense item:
Therefore, permanent differences result from revenues and expenses that are reportable on either tax returns or in financial statements but not both. Permanent differences arise because the tax code excludes certain revenues from taxation and limits the deductibility of certain expenses.
These differences are permanent because they will not reverse in future periods. No deferred tax consequences are recognized for permanent differences; however, they result in a difference between the effective tax rate and the statutory tax rate that should be considered in the analysis of effective tax rates. Example A company owns a $50,000 municipal bond with a 4% coupon and has an effective tax rate of 50% and a statutory tax rate of 40%. Calculate the deferred tax created by this bond. Solution The bond does not result in deferred tax, as the difference it causes is a permanent difference that will not reverse. As a result, no deferred tax is recognized. Temporary differences result in deferred tax liabilities or assets. Different depreciation methods or estimates used in tax reporting and financial reporting are a common cause of temporary differences. There are two categories of temporary differences. Taxable Temporary Differences (TTD)
Items that give rise to taxable temporary differences are:
Deductible Temporary Differences (DTD)
Items that give rise to deductible temporary differences are:
 Learning Outcome Statements f. identify and contrast temporary versus permanent differences in pre-tax accounting income and taxable income; CFA® 2022 Level I Curriculum, Volume 3, Module 23 The cause of deferred tax assets and liabilities What are Permanent/Temporary Differences in Tax Accounting?As described in CFI’s income tax overview, the difference in accounting for taxes between financial statements and tax returns creates a permanent and temporary differences 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 the difference between the tax expense and tax payable caused by an item that does not reverse over time. In other words, it is the 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 advance 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 pretax 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 revenues 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. Related ReadingsThank you for reading CFI’s guide to Permanent/Temporary Differences in Tax Accounting. To keep learning and developing your knowledge of financial analysis, we highly recommend the additional CFI resources below:
What are typical temporary differences between taxable and pretax accounting income?Temporary differences between them
Because the tax code and GAAP differ, a company might record a difference between taxable income and pre-tax income at a specific point in time only. One common example of this is depreciation. Depreciation is the reduction in an asset's value over time.
Which of the following typically causes a permanent difference between taxable income and pretax accounting income?Which of the following causes a permanent difference between taxable income and pretax accounting income? Interest income on municipal bonds. In reconciling net income to taxable income, interest earned on municipal bonds is: A permanent difference.
What causes temporary tax differences?Temporary differences arise when business income or expenses are recognized in different periods on the financial statements than on the tax returns. These differences might include revenue recognition, expenses incurred but not yet paid or depreciation calculation differences, reports Finance Train.
Which of the following creates a temporary difference between financial and taxable income?A temporary difference exists because depreciation deduction for tax purpose and financial reporting purpose.
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Which of the following causes a temporary difference between taxable and pretax accounting income
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