Thursday, May 26, 2022

Temporary vs. Permanent Tax Differences in Financial Accounting

In this video we're going to discuss temporary and permanent differences between book income and taxable income now remember book income and taxable income are not the same thing they're not equal to each other in the United States because book income refers to income reported from your income statement for financial reporting .

Purposes whereas taxable income is reported to the IRS to determine how much money a corporation owes in taxes so they have different objectives and they're calculated in different ways so they're not the same thing in the United States now these differences between bulk income and tacking tax income could be their temporary in which case they .

Will reverse in this future period and ultimately the same amount of deductions are taken it's just a timing difference or it could be permanent difference in which case there's never going to be a reversal for example income from life insurance proceeds is never going to be taxable it's never going to be part of taxable income however it is part of .

Book income and that's not going to reverse at any point in the future so I want to give you an example to show you the difference between temporary and permanent differences in taxes so let's say that you purchase a fixed asset some some depreciable asset for $60,000 and you estimate that it has a useful life of five years and so we're going to look .

At how the difference is in depreciation for both book and tax purposes can create where a situation where we have a temporary difference so let's say that we decide for book purposes we just we depreciate this asset over five years and so we've got your one your two-year three or four your five let's say there's no salvage value so we do .

Straight-line method 60,000 divided by five is 12,000 of depreciation taking every single year for each year that we have the asset right now let's say for tax purposes usually tax it accelerates the depreciation this is actually it's basically the government is doing a favor to businesses to encourage them to invest and to accelerate their .

Deductions so that they get the same number of deductions they still are depreciation if you add up all the depreciation it's sixty thousand dollars over the life of the asset so they're still taking sixty thousand in deductions but they're going to take the deductions in larger amounts in earlier years and then in lower amounts in later .

Years so it's accelerating the deductions because the time value of money is it's basically a good thing for this business right so they're going to get to deduct twenty thousand dollars in year one however the amount that they deduct goes down over time and by the end of the final year of the asset they only deduct .

Four thousand so if we think about the extra deductions of taxes overbook deductions we can compute it by saying okay well let's take there's twenty thousand – or twelve thousand and so in year one the excess of tax deduction over book is eight thousand so that means according to tax purposes there's a difference of this eight thousand .

Extra deduction and because there's two twenty thousand tax depreciation versus twelve thousand of book now in year two it's going to be four thousand excess of tax over book and year three it'll be zero there's no difference and then in your four it's actually going to be book book ends up with more in deductions and then in year five is eight thousand now .

If we add up if we add up this column right here it's going to give us if we have eight thousand plus four thousand is twelve thousand – four thousand – eight thousand is going to give us zero and what what you'll see is that we have we've taken sixty thousand and depreciation each way each way so if we look in year one and you're wanting you .

Say hey look we took the different amount of depreciation but later it reversed it reversed later so that means that basically we have a difference in year one right but it's going to change later so what we actually have is a thing called a deferred tax liability and and we'll talk about deferred tax liabilities and deferred tax assets in a .

Future video but I just want to share with you now that this eight thousand and this four thousand those differences they later verse they later reversed so it's simply a timing thing in each case whether it's tax or bulk we end up taking a total of $60,000 in deductions and so that is a temporary that's a temporary tax .

Difference because it reverses okay now sometimes you'll have a situation where there's a permanent tax difference right so a permanent tax difference is never going to reverse so it's not going to be like oh well we're going to take more deductions in year one but then less and your five a permanent a permanent difference never reverses so I want to .

Give a giving example we'll take the example of the life insurance proceeds so let's say that you and I start a band we start a band called rock and roll incorporated and we get insurance on each other and you get insurance on me I'm playing the guitar and you say look if this guy dies you know I could have an issue here so you get life insurance .

You get a life insurance on me a life insurance policy and then and then let's say that I died in a tragic accident trying to climb the st. Louis Arch with suction cups I try to climb the arch and I end up falling and dying unfortunately but the company because you have this life insurance policy you get two million dollars so you receive two .

Million dollars and now the question is okay well what happens at two million is that income so that is not taxed right so two million dollars is is tax-free from the perspective of when you're filing the corporate tax return because life insurance proceeds are exempt from taxable income so this is going to be tax-free however when you're putting .

Together the financial statements when you're putting together the financial statements and calculating pre-tax financial income you're going to include that two million dollars so we'd say for book income purposes we're going to have two million dollars in income right because there's life insurance proceeds but for tax purposes this transaction .

This life insurance proceeds is actually going to give zero right so there's no income recognized that two million now here's the thing this is permanent because it never reverses it doesn't matter so once this transaction happens is the two million is done it's not like oh five years later then there will be two .

Million of tax income and that and zero of book it does not reverse and so that means it's a permanent difference this this life insurance it proceeds is going to create a permanent difference between book and tax income and for that reason we're not going to create a deferred tax assets liability which items which we're going to talk about in the videos to .



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