Permanent Difference

Definition

A permanent difference is a discrepancy between the reported profit or loss for tax purposes and the profit or loss reflected in the financial statements. These differences arise permanently and are not expected to reverse in future periods. Typically, this happens because certain revenues or expenses are recognized for financial reporting purposes but are either non-deductible or non-taxable according to tax laws.

For instance, in the UK, entertaining expenditures are recorded as an expense in the financial statements of a company. However, these expenditures are not deductible when deriving the profit or loss for tax purposes. Hence, this creates a permanent difference.

Examples

Entertaining Expenses: As noted, expenses related to client entertainment may be recognized in financial statements but not allowed as a tax deduction.
Fines and Penalties: Any fines or penalties paid are typically expensed in the financial statements but are non-deductible for tax purposes.
Municipal Bond Interest: Interest income from municipal bonds may be recognized in financial statements but is often exempt from federal taxes in the U.S.
Life Insurance Proceeds: Proceeds from life insurance policies are typically excluded from taxable income but may be recorded in the financial statements.

Frequently Asked Questions (FAQs)

What causes a permanent difference?

Permanent differences arise due to differing treatments of income and expenses under accounting principles and tax laws, resulting in a permanent variance between reported and taxable profits.

How do permanent differences impact deferred tax calculations?

Permanent differences do not give rise to deferred tax assets or liabilities because they do not reverse over time, unlike temporary differences which can eventually affect tax positions in future periods.

Are permanent differences included in tax expense reconciliation?

Yes, companies often include permanent differences in their tax expense reconciliation to explain disparities between the effective tax rate and the statutory tax rate.

Can permanent differences change over time?

No, by definition, permanent differences do not reverse over time; they are constant and enduring as long as the particular item remains in existence under the applicable tax laws and accounting standards.

What is an example of a temporary difference?

An example of a temporary difference is depreciation, where the method and rate of depreciation can differ for financial reporting and tax purposes, leading to a temporary variance that may equalize over time.

Temporary Difference: Variances between tax reporting and financial reporting that reverse over time, leading to deferred tax assets or liabilities.
Deferred Tax Asset: A tax reduction available in future periods due to deductible temporary differences and carry forwards.
Deferred Tax Liability: A tax obligation payable in future periods resulting from taxable temporary differences.
Effective Tax Rate: The average rate at which income is taxed, considering all applicable taxes.
Statutory Tax Rate: The legally imposed rate at which income is taxed.

Online References

Suggested Books for Further Studies

Intermediate Accounting by Donald E. Kieso, Jerry J. Weygandt, and Terry D. Warfield - This book provides a detailed overview of accounting principles and the treatment of permanent differences.
Financial Accounting by Robert Libby, Patricia Libby, and Frank Hodge - This textbook covers foundational concepts in financial accounting, including tax-related accounting issues.
Taxation of Business Entities by J. David Spiceland and Jana Raedy - This book delves into the principles of tax accounting, including permanent and temporary differences.
Income Tax Fundamentals by Gerald Whittenburg and Martha Altus-Buller - A practical guide on income tax preparation and compliance, featuring discussions on permanent differences.

Accounting Basics: “Permanent Difference” Fundamentals Quiz

### Which of the following is a common example of a permanent difference? - [ ] Depreciation - [x] Entertaining expenses - [ ] Bad debt expense - [ ] Warranty expense > **Explanation:** Entertaining expenses are commonly included in financial statements but may be non-deductible for tax purposes, thereby creating a permanent difference. ### Can interest income from municipal bonds cause a permanent difference? - [x] Yes - [ ] No - [ ] It depends on the locality. - [ ] Only if the bonds are from a federal entity. > **Explanation:** Interest income from municipal bonds is often exempt from federal taxes, which creates a permanent difference since it is reported in financial statements but excluded from taxable income. ### Do permanent differences create deferred tax assets or liabilities? - [ ] Yes, only deferred tax assets. - [ ] Yes, only deferred tax liabilities. - [ ] Yes, both deferred tax assets and liabilities. - [x] No, they do not create deferred tax items. > **Explanation:** Permanent differences do not create deferred tax assets or liabilities because they do not reverse over time and thus have no future tax implications. ### What type of variance can an instance of municipal bond interest income create? - [x] Permanent difference - [ ] Temporary difference - [ ] Reversal difference - [ ] Provisional difference > **Explanation:** Since municipal bond interest income is often exempt from federal taxes and recognized in financial statements, it results in a permanent difference. ### Why do permanent differences not give rise to deferred tax assets or liabilities? - [x] Because they are not expected to reverse in future periods. - [ ] Because they always reflect taxable income correctly. - [ ] Because the IRS permits adjusting such differences. - [ ] Because they are provisional and change each year. > **Explanation:** Permanent differences do not give rise to deferred tax items because they do not reverse over time, meaning the tax effect is permanent and not deferred. ### Which type of tax expense is reconciled with permanent differences? - [x] Effective tax rate - [ ] Depreciation expense - [ ] Allowance for doubtful accounts - [ ] Accrued liability expense > **Explanation:** Permanent differences are often reconciled with the effective tax rate to explain the difference between a company’s financial statement tax expense and the taxes actually payable. ### Which of the following is NOT an example of a permanent difference? - [ ] Municipal bond interest income - [x] Different depreciation methods under tax laws and GAAP - [ ] Fines and penalties - [ ] Life insurance proceeds > **Explanation:** Different depreciation methods under tax laws and GAAP create temporary differences that reverse over time, unlike permanent differences. ### What is the nature of fines and penalties in accounting and tax reporting? - [ ] Deductible under all circumstances - [ ] Reversible temporary differences - [x] Non-deductible, permanent differences - [ ] Allowance-based differences > **Explanation:** Fines and penalties are non-deductible for tax purposes but are typically expensed in financial statements, causing permanent differences. ### How does life insurance proceeds affect the financial and tax reporting? - [ ] Deductible in both reports - [x] Tax-exempt but recognized in financial reports - [ ] Creates a temporary difference - [ ] Adjusts deferred tax liability > **Explanation:** Life insurance proceeds are generally exempt from taxable income but are recognized in financial statements, causing permanent differences. ### Which element is more likely associated with permanent differences than temporary differences? - [ ] Asset write-downs - [ ] Deferred revenues - [x] Non-deductible expenses - [ ] Unearned revenue > **Explanation:** Non-deductible expenses such as certain fines or entertaining expenses are often permanent differences as they don't reverse over time.

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