Temporary differences are differences between financial accounting and tax accounting rules that cause the pretax accounting income subject to tax to be higher or lower than the taxable income in current period and lower or higher by an equal amount in future periods.
Temporary differences differ from permanent differences because permanent differences result in irreversible differences between taxable income and accounting income but the temporary differences are expected to reverse in future.
There are two types of temporary differences: taxable temporary differences and deductible temporary differences. Temporary differences have deferred tax implications.
Taxable temporary differences
Taxable temporary differences are timing differences which cause taxable income in current period to be lower than pretax accounting income subject to taxes and hence income tax payable in current period to be lower than the accrual income tax expense. The difference between the income tax payable and the accrual income tax equals the deferred tax liability.
Example and journal entry: deferred tax liability
Let’s consider an example where the pretax accounting income is $40 million, net permanant differences are $1.5 million (i.e. $2 million of exempt income and $0.5 million of non-deductible expense). Assume that included in the accounting income for tax purposes is a depreciation charge of $3 million on straight-line basis while tax rules allow depreciation of $5 million. It means that the taxable income is lower than accounting income for tax purposes by $2 million (=$5 million - $3 million). It is a taxable temporary difference because in future periods tax depreciation will be lower resulting in higher income tax payable. Hence, that increased future tax must be recognized today by recording a deferred tax liability of $800,000. The following journal entry must be passed:
|Deferred tax expense||800,000|
|Deferred tax payable||800,000|
Deductible temporary differences
Deductible temporary differences are differences which cause the taxable income and hence income tax payable in current period to be higher than the accrual income tax. They result in deferred tax asset which is expected to be utilized in future periods to plug the difference between the lower taxable income and income tax payable in future periods.
Example and journal entry: deferred tax asset
Let’s assume that the accounting income for tax purpose included taxation of a $5 million rent received in advance half of which relates to the next financial year. This is a deductible temporary difference because it causes the future period income tax payable to be lower than the accrual income tax. A deferred tax asset must be recognized assuming sufficient taxable income will be available in future. It would be recognized using the following journal entry:
|Deferred tax asset||1,000,000|
|Deferred tax expense||1,000,000|
Current tax vs deferred tax
Deferred tax liabilities and assets are just a process through which a chunk of income tax is moved between different times periods.
Let’s reconcile accrual income tax expense with income tax payable:
|Taxable income and income tax payable||Calculation||USD in million|
|Pretax accounting income||EBT||40.00|
|Less: exempt income (municipal bond interest)||EI||(2.00)|
|Add: non-deductible expense (fines)||NDE||0.50|
|Accounting income for tax purposes||EBTT=EBT-EI+NDE||38.50|
|Corporate tax rate||R||40%|
|Income tax expense||T = R × EBTT||15.40|
|Add: unearned revenue recognized for tax purposes||UER||2.5|
|Less: tax depreciation||TD||(5.00)|
|Add: accounting depreciation||AD||3.00|
|Corporate tax rate||R||40%|
|Income tax payable||ITP=TI×R||15.60|
|Less: deferred tax expense||DT||(0.20)|
|Income tax expense on income statement||T=ITP + DT||15.40|
During the current financial year, your income statement will show current tax expense of $15.4 million and a net deferred tax expense of -$200,000 and your balance sheet will show a deferred tax asset of $1 million and a deferred tax liability of $800,000.