What are permanent differences in accounting?

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 LiabilityInstallment SalesRevenue TodayIncome LaterYesProduct WarrantiesExpense TodayDeduction LaterYesBad Debt ExpenseExpense TodayDeduction LaterYesRent Rec’d in AdvanceRevenue LaterIncome TodayYesDepreciation ExpenseStraight-LineAcceleratedYesPrepaid ExpensesExpense LaterDeduction TodayYesImpairmentExpense 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.

The financial accounting term permanent differences typically refers to transactions that are recognized for financial reporting purposes but not for income tax purposes. Although less common, permanent differences can also refer to transactions that are recognized for income tax purposes, but not for financial reporting purposes.

When a permanent difference exists, the journal entries for the transactions will not affect deferred income tax.

Explanation

Companies will typically have two sets of books: financial accounting (book) and income tax. A difference occurs when the calculation of net income for accounting purposes varies from that determined for income tax purposes.

Permanent differences can occur for a number of reasons; although most differences are temporary in nature and are referred to as timing differences. While a timing difference involves reversing entries that will eventually account for the variance between the two sets of books, permanent differences do not require future journal entries to reverse the variance.

Financial accounting refers to the generally accepted accounting principles used to create financial statements for the public, while tax accounting follows the rules of the Internal Revenue Service. The rules for the two types of accounting are not always the same. Permanent differences in accounting arise when the rules for financial accounting permit a transaction not allowed in tax accounting or vice versa.

Financial Accounting

1. Examples of items recognized by financial accounting but not allowed by tax law are interest income received on tax-exempt securities, life insurance premiums paid for key officers or employees, fines and expenses for violating the law, and book depreciation in excess of the amount allowed by tax law. These items are recorded in a business's books but never on a tax return.

Tax Accounting

1. Examples of items allowed by tax law but not by financial accounting include the dividends-received deduction and the deduction for percentage depletion of natural resources in excess of their cost. These items are part of a tax return but never recorded in a business's books.

Another Example

1. Another item that creates a permanent difference is expenses for meals and entertainment. The IRS generally allows only a 50 percent deduction for these expenses, while the financial statements record 100 percent of the expenses.

Permanent vs. Temporary Differences

1. Permanent differences have no effect on the taxes or other aspects of a business and are easy to deal with from an accounting perspective. What is harder to deal with are temporary differences, because they require more tracking and understanding of the tax code. Temporary differences arise when financial accounting permits recording a transaction in one tax period, while tax accounting requires recording the transaction in another tax period. Temporary differences often create deferred taxes, but permanent differences do not.

Considerations

1. Both tax law and generally accepted accounting principles are always changing, plus many exceptions to the general rules exist, so using the services of accounting and tax experts is always a good idea for a business.

   What are examples of permanent differences?

   Common examples of permanent differences include entertainment expenses, the 50% limitation on the deduction of certain meal expenses, penalties, social club dues, lobbying expenses, and tax-exempt municipal bond interest.

   What is permanent differences and temporary difference?

   Temporary differences occur whenever there is a difference between the tax base and the carrying amount of assets and liabilities on the balance sheet. Permanent differences are differences between the tax and financial reporting of revenue or expense items that will not be reversed in future.

   What is temporary difference in accounting?

   What is a Temporary Difference? 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.

   What are examples of temporary differences?

   7 include examples of transactions or events that can result in temporary differences for both categories noted above..

   1 Temporary differences—business combinations. ... .

   2 Temporary differences—indefinite-lived assets. ... .

   3 Temporary differences—inflation indexation. ... .

   4 Share based compensation. ... .

   5 Investment tax credits..