If there is a difference between tax and financial reporting of revenue or expense that can’t be reversed in future, it is called a permanent difference.
If there exists a difference between tax base and the number of assets or liabilities which can be corrected in due time, it is called a temporary difference.
There are many examples of temporary differences and permanent differences.
Usually, the statement of expense incurred comes earlier and the tax payable statement comes later, these differences are perfect examples of temporary differences and permanent differences.
A temporary difference occurs when the pretax book income and the taxable income are reported differently. But this difference can be reversed in due course of time.
In simple terms, this means that the transaction creates temporary differences in the financial statement which is recognized by both the tax department and the financial accounting department but at different time slots. This is the core reason why temporary differences are also referred to as timing differences sometimes.
Examples of temporary differences:
Rental income is one of the best examples of temporary differences. The revenue is recorded only when it is collected by the accrual accounting, but if the business has received the payment – in advance – in the name of rental income then it has to be reported under the taxable income in the name of tax return. A difference is recorded. It is a temporary difference as it is rectified as soon as the actual revenue is collected.
Once the revenue is collected, the amount is reversed or eliminated so that there is no error in the financial statement.
Another example of temporary difference is the prepayment of a work. If a business receives the payment before the work is completed, the payment is not recognized as revenue on the balance sheet. it needs to be reversed, once the actual work is done. This needs to be done to rectify the statement, else this will decipher further in the financial statement, leading to wrong entry in the balance sheet.
Permanent differences are the differences incurred between the tax expense and the tax payable which is caused by a certain item that is irreversible over time. In simpler terms, a permanent difference is a difference between tax accounting and financial accounting which can never be rectified or eliminated. A permanent difference will also create a difference among the statutory tax rate and the effective tax rate. As the permanent difference can never be eliminated, the tax difference usually does not generate deferred taxes as observed in temporary differences.
Examples of permanent differences:
A classic example of permanent differences is a company facing a financial situation. The tax code rarely ever allows a deduction to pay a fine. But the fines are supposed to be deducted from the income as per the books of accounting. Therefore, this is a permanent difference in the record books that cannot be eliminated, as the fine has been paid.
Another example of permanent differences is interest on municipal bonds. The difference is allocated on its reserved time which can cause a permanent difference in the financial statement. Because interest has to be paid, therefore this change is also termed as permanent differences.
Penalties, meals and entertainment, special dividends and life insurance premiums are all examples of permanent differences. None of the mentioned commodities can be reversed, therefore the change in the balance sheet is permanent.
The effects of these differences on financial accounting
A permanent difference is irreversible, and is most impactful at the time it occurs. Usually, the impact on the balance sheet is that the effective tax rate in the books will be recorded either higher than the actual rate of return, or lower than the actual effective tax return of the company.
A temporary difference creates a more complex problem for the company compared to the permanent difference. A temporary difference causes a pretax income which can be higher than the actual taxable income resulting in a tax liability. This happens because the company earns more revenue than it has mentioned in the financial statement, while the tax returns still need to be allocated.
As the temporary difference is eventually reversed, the company will generate higher revenues, thus incurring higher taxes on its tax returns for a long period of time. If there is lower-income recorded in the book, this will also cause a deferred tax asset, again for a long period of time, but reversible.