Temporary tax differences are timing discrepancies between taxable and accounting income that will eventually reverse, while permanent tax differences are items that affect only one system and never reverse, impacting only the current tax expense.
Temporary Tax Differences: These differences occur when the tax base of an asset or liability differs from its carrying amount in the financial statements but will reverse over time. Essentially, these differences affect taxable income only temporarily and result in deferred tax assets or liabilities. Common examples include differences in depreciation methods used for tax and accounting purposes or revenue recognized in one period for financial reporting but in another period for tax purposes. These differences eventually balance out as the asset or liability is realized or settled.
Permanent Tax Differences: These differences arise from items that are included in financial income but are never taxable, or expenses that are recognized in financial income but are not tax-deductible. Unlike temporary differences, permanent differences do not reverse over time. They cause a lasting discrepancy between taxable income and accounting profit. Examples include fines and penalties, tax-exempt interest income, and certain non-deductible business expenses like political contributions.
The key distinction is that temporary differences affect the timing of tax payments, while permanent differences affect the overall tax burden and contribute to discrepancies between the effective and statutory tax rates.
