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 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

Def. Tax Asset

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

Carrying Amount Vs. Tax

Base
Carrying Amount > Tax Base
Carrying Amount < Tax Base
Carrying Amount > Tax Base
Carrying Amount < Tax Base

Result
Deferred tax liability
Deferred tax asset
Deferred tax asset
Deferred tax liability

Temporary differences can be of two types:

Taxable temporary differences: These differences result in future taxable income.

Deductible temporary differences: These differences result in future tax deductions.

What is a 'Deferred Tax Liability'

A deferred tax liability is an account on a company's balance sheet that is a result of temporary
differences between the company's accounting and tax carrying values, the anticipated and
enacted income tax rate, and estimated taxes payable for the current year. This liability may be
realized during any given year, which makes the deferred status appropriate.
Because there are differences between what a company can deduct for tax and accounting
purposes, there is a difference between a company's taxable income and income before tax. A
deferred tax liability records the fact the company will, in the future, pay more income tax

because of a transaction that took place during the current period, such as an installment sale
receivable.

BREAKING DOWN 'Deferred Tax Liability'

Because U.S. tax laws and accounting rules differ, a company's earnings before taxes on the
income statement can be greater than its taxable income on a tax return, giving rise to a deferred
tax liability on the company's balance sheet. The deferred tax liability represents a future tax
payment a company is expected to make to appropriate tax authorities in the future, and it is
calculated as the company's anticipated tax rate times the difference between its taxable income
and accounting earnings before taxes.

Examples of Deferred Tax Liability Sources

A common source of deferred tax liability is the difference in depreciation expense treatment by
tax laws and accounting rules. The depreciation expense for long-lived assets for financial
statements purposes is typically calculated using a straight-line method, while tax regulations
allow companies to use an accelerated depreciation method. Since the straight-line method
produces lower depreciation when compared to that of the underaccelerated method, a company's
accounting income is temporarily higher than its taxable income. The company recognizes the
deferred tax liability on the differential between its accounting earnings before taxes and taxable
income. As the company continues depreciating its assets, the difference between straight-line
depreciation and accelerated depreciation narrows, and the amount of deferred tax liability is
gradually removed through a series of offsetting accounting entries.
Another common source of deferred tax liability is an installment sale, which is the revenue
recognized when a company sells its products on credit to be paid off in equal amounts in the
future. Under accounting rules, the company is allowed to recognize full income from the
installment sale of general merchandise, while tax laws require companies to recognize the
income when installment payments are made. This creates a temporary positive difference
between the company's accounting earnings and taxable income, as well as a deferred tax
liability.

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.

Liabilities - Permanent Vs. Temporary Items

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: