What is the difference between permanent and temporary differences in deferred tax accounting?

Question

AcadiFi · Accepted Answer

This is one of the most important — and most confusing — topics in CFA Level I FRA. Let me break it down clearly.

```mermaid
flowchart TD
    A["Difference Between
Tax and Accounting"] --> B{"Will it reverse
in the future?"}
    B -->|Yes| C["Temporary Difference"]
    B -->|No| D["Permanent Difference"]
    C --> E{"Taxable income >
Accounting income
in future?"}
    E -->|Yes| F["Deferred Tax Liability (DTL)"]
    E -->|No| G["Deferred Tax Asset (DTA)"]
    D --> H["No DTA or DTL
Affects effective tax rate"]
```

**Temporary Differences (create DTAs or DTLs):**

These are differences between the tax base and carrying amount of an asset or liability that will reverse in the future.

| Example | Tax vs. Book | Creates |
|---------|-------------|--------|
| Accelerated tax depreciation vs. SL book depreciation | Tax depreciation higher now, lower later | **DTL** (pay more tax later) |
| Warranty provision (expensed on books, deducted when paid for tax) | Tax deduction later | **DTA** (pay less tax later) |
| Installment sale (revenue on books now, taxed when collected) | Tax income later | **DTL** |
| Tax loss carryforward | Deduction available in future | **DTA** |

**Example:** Fenwick Manufacturing uses straight-line depreciation for financial reporting ($50,000/year) but accelerated depreciation for tax ($80,000 in year 1). Tax rate = 25%.

- Year 1 difference: $80,000 - $50,000 = $30,000 temporary difference
- DTL created = $30,000 x 25% = **$7,500**
- This will reverse when tax depreciation is lower than book depreciation in later years

**Permanent Differences (no DTAs or DTLs):**

These are items that appear in either the tax return or the financial statements but **never** in the other. They never reverse.

| Example | Why Permanent |
|---------|-------------|
| Tax-exempt municipal bond interest | Income on books, never taxed |
| Fines and penalties | Expense on books, never deductible for tax |
| Meals and entertainment (50% non-deductible) | Partial expense on books, never fully deductible |
| Life insurance premiums on key employees | Expense on books, not deductible |

**Impact on effective tax rate:**

Permanent differences cause the effective tax rate to differ from the statutory rate. If Fenwick earns $500,000 pretax and has $20,000 in tax-exempt interest:
- Taxable income = $500,000 - $20,000 = $480,000
- Tax payable = $480,000 x 25% = $120,000
- Effective tax rate = $120,000 / $500,000 = **24.0%** (below the 25% statutory rate)

The tax-exempt interest permanently reduces the effective rate. Temporary differences do not affect the effective rate — they only affect timing.

**Exam tip:** If a question asks which items create deferred tax, eliminate permanent differences first. If it asks about the effective tax rate reconciliation, focus on permanent differences. This distinction is worth memorizing.

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What is the difference between permanent and temporary differences in deferred tax accounting?

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Related Questions

Practice Questions

Example	Tax vs. Book	Creates
Accelerated tax depreciation vs. SL book depreciation	Tax depreciation higher now, lower later	DTL (pay more tax later)
Warranty provision (expensed on books, deducted when paid for tax)	Tax deduction later	DTA (pay less tax later)
Installment sale (revenue on books now, taxed when collected)	Tax income later	DTL
Tax loss carryforward	Deduction available in future	DTA

Example	Why Permanent
Tax-exempt municipal bond interest	Income on books, never taxed
Fines and penalties	Expense on books, never deductible for tax
Meals and entertainment (50% non-deductible)	Partial expense on books, never fully deductible
Life insurance premiums on key employees	Expense on books, not deductible