Temporary (or timing) differences between book income versus taxable income are due to items of revenue or expense that are recognized in one period for taxes, but in a different period for the books. Book recognition can come before or after tax recognition. These revenue and expense items cause a timing difference between the two incomes, but over the "long run", they cause no difference between the two incomes. This is why they are temporary. When the difference first arises, it is called "an originating timing difference". When it later reverses it is called "a reversing timing difference". Here are two examples of temporary differences: (1) the calculation of depreciation expense by means of the straight-line method for books and by means of an accelerated method for taxes, and (2) the calculation of bad-debts expense by means of the allowance method for books and by means of the direct write-off method for taxes.

Over the life of the firm, total depreciation expense and bad debts expense are unaffected by the method. What is affected is how much expense is recognized in any given period. Temporary differences are said to "reverse" because if they cause book income to be higher (or lower) than taxable income in one period, they must cause taxable income to be higher (or lower) than book income in another period.

Permanent differences are differences that never reverse. That is, they are items of book (or tax) revenue or expense in one period, but they are never items of tax (or book) revenue or expense. They are either nontaxable revenues (book revenues that are nontaxable) or nondeductible expenses (book expenses that are nondeductible). Examples of permanent differences are (nontaxable) interest revenue on municipal bonds and (nondeductible) goodwill (GW) amortization expense under the purchase method for acquisitions. A good example of GW amortization is when one company purchases another company or any asset at a price that exceeds its recorded book value. This would be recognized partially at the time of purchase and partially over a period of time using standard amortization schedules. These are often referred to non-cash items of expenses or revenues and again are heavily scrutinized by analysts.

Calculating Income Tax Expense, Income Taxes Payable, Deferred Tax Assets, and Deferred Tax Liabilities
We'll explain this concept by example:

Company ABC purchased a machine for $2m with a salvage value of $200,000. It used the accelerated depreciation method for tax purposes and straight-line depreciation for reporting purposes. Tax rate is 40%.


Tax differential:


Make sure you know the following for your exam:
  1. Total tax bill is the same.
    • Timing differences create a tax liability.

Calculation:
Income tax expense = reported income before tax * tax rate
Income tax payable = IRS reported income * tax rate
Deferred tax liability (asset) = income tax expense - income tax payable

Figure 9.1: Cumulative Effect of Total Taxes



Adjustments To Financial Statements From Tax Rate Changes

Related Articles
  1. Taxes

    Deferred Tax Liability

    Deferred tax liability is a tax that has been assessed or is due for the current period, but has not yet been paid. The deferral arises because of timing differences between the accrual of the ...
  2. Taxes

    Deferred Tax Asset

    A Deferred Tax Asset is an asset on a company’s 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 ...
  3. Taxes

    Understanding Income Tax

    Income tax is a levy many governments place on revenue of entities within their jurisdiction.
  4. Taxes

    Taxes: Who Pays And How Much?

    When it comes to taxes, the debate is endless on who pays what, especially in Congress. With no new initiatives in sight, let's take a look at who is paying now.
  5. Taxes

    Which Countries Have the Highest Taxes on High Incomes?

    These countries charge the highest taxes on high incomes.
  6. Taxes

    How Much Tax Do You Really Pay?

    When you add direct and indirect taxes together, your real tax rate is much more than you expected.
  7. Insights

    How Fortune 500 Companies Avoid Paying Income Tax

    President Donald Trump is not alone in not paying taxes.
  8. Taxes

    What's a Marginal Tax Rate?

    The marginal tax rate is based on a progressive tax system, where tax rates for an individual will increase as income rises. This method of taxation aims to fairly tax individuals based upon ...
  9. Investing

    Book Value: How Reliable Is It For Investors?

    In theory, a low P/B ratio means you have a cushion against poor performance. In practice, it is much less certain.
Frequently Asked Questions
  1. What is the difference between a capital expenditure and a revenue expenditure?

    Capital expenditures represent major investments of capital that a company makes to expand its business and generate additional ...
  2. What is the difference between revenue and income?

    Revenue is simply the total amount of cash generated by the sale of products or services associated with the company's primary ...
  3. How can my stock's price change after hours, and what effect does this have on investors? Can I sell the stock at the after-hours price?

    When the regular market opens for the next day's trading, stocks may not necessarily open at the same price at which it traded ...
  4. What's the difference between a 401(k) and a Roth IRA?

    A 401(k) and a Roth IRA differ primarily on tax treatment, investment options, employer involvement, and limitations on contributions ...
Trading Center