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Interperiod Tax Allocation: Permanent & Temporary Differences

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  • 0:04 Accounting
  • 1:47 Interperiod Tax Allocation
  • 3:40 GAAP vs. Tax Accounting
  • 9:21 Deferred Tax Assets &…
  • 11:55 Lesson Summary
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Lesson Transcript
Instructor: Michael Eagan

Michael teaches tax, accounting and finance courses and has a law degree, an MBA, and an LL.M in Taxation.

This lesson discusses differences between GAAP and tax accounting - known in practice as permanent and temporary differences - and the interperiod tax allocation issue resulting from temporary differences.

Accounting

You're a senior tax manager at a large accounting firm. A junior associate walks into your office with a glazed look on her face.

''What's wrong?'' you ask.

''It's this tax provision I'm working on. I cannot seem to grasp deferred taxes,'' she replies. ''Sit down,'' you tell her. ''Let's talk.''

''Let's start with the basic role deferred taxes plays in the calculation of income tax expense.''

Total income tax expense for a given period, you explain to your colleague, consists of two components: a ''current'' component and a ''deferred component.'' The current piece, or current income tax expense, you explain, is generally current period taxable income, as determined under US tax law, multiplied by the relevant applicable tax rate.

The deferred component, or deferred tax expense, is equal to the change in recognized ''deferred tax assets'' (DTAs) and ''deferred tax liabilities'' (DTLs) during the period. DTAs and DTLs result from, in the language of the guidance (ASC 740) ''taxable temporary differences'' and ''deductible temporary differences,'' also referred to in practice as taxable amounts and deductible amounts, which, in turn, are a result of temporary differences between GAAP and tax accounting.

That's a lot of lingo, and we will get into more detail on DTAs and DTLs later, but understand at this point that deferred tax assets and deferred tax liabilities result from certain differences in Generally Accepted Accounting Principles (GAAP) and tax accounting.

Interperiod Tax Allocation

As we will see, GAAP and tax accounting frequently differ because different rules and standards determine each. Financial statement pre-tax income is determined based on GAAP rules, principles, and concepts (such as recognition and matching), whereas taxable income is determined under U.S. tax law. The recognition, and the timing of recognition, of income and expense frequently differ. These differences are either ''permanent'' or ''temporary.'' Only temporary differences lead to deferred tax assets or liabilities and, therefore, impact deferred tax expense.

Unlike permanent differences between GAAP and tax, temporary differences affect multiple years and create a conceptual matching issue called interperiod tax allocation. The matching issue is that because temporary differences affect multiple years, the tax effect of an item must be matched under GAAP's matching principle to the year that item impacts the financial statements.

Many of these differences reverse over time. Depreciation expense, for example, will likely differ under GAAP and tax because of different useful lives and/or depreciation methods. This difference creates a difference in asset basis between GAAP and tax that affects multiple years, but that difference reverses over time as the asset depreciates or when the asset is sold, in which case the reversal is reflected in the differing gain amounts.

Permanent differences, on the other hand, only impact a single year, and thus, do not create a matching or interperiod allocation issue. In the case of permanent differences, there are no tax consequences in a prior or subsequent year.

GAAP vs. Tax Accounting

Let's better understand how GAAP and tax accounting may differ and whether those differences are permanent or temporary. Differences between GAAP and tax accounting are usually the result of one of four circumstances, three of which give rise to temporary differences.

GAAP's rules for recognizing income and expense often differ from those under U.S. tax law for certain items of income, gain, expense, or loss. This results in either (1) GAAP recognizing income or expense that tax does not or (2) vice-versa. For example:

  • Municipal bond interest is recognizable GAAP income but is specifically excluded from taxable income under the tax law.
  • The dividends received deduction available to corporate taxpayers by the tax law is deductible for tax purposes but is not a GAAP expense.
  • The tax deduction for travel and entertainment expenses is limited to 50 percent of the total but are fully deductible for GAAP purposes.

These recognition differences tend to create permanent differences. They impact the calculation of either GAAP pre-tax income or taxable income, but not both, in the current period only and, therefore, do not raise the interperiod allocation issue. They are not timing differences because either GAAP or tax recognizes income or expense, but the other never will. Thus, only a single year is affected.

Even if GAAP and tax agree on the recognition of an item of income or expense and the amount, the timing of that income or expense may differ between GAAP and tax. These types of differences are the most common temporary differences. They affect multiple years and create a temporary difference between GAAP and tax asset basis. The simplest example is, as we saw, depreciation expense, the timing of which likely differs under GAAP and tax. Other examples include:

  • Situations where GAAP recognizes income earlier than tax, such as sales subject to the tax code's installment method, which applies to certain sales on credit and defers gain on sale to subsequent years as payments are received.
  • Instances where tax recognizes income earlier than GAAP, such as subscription income or advance rent where cash is received and generally subject to tax before that income is 'earned' for GAAP purposes.
  • Situations where GAAP recognizes an expense before a tax deduction is allowed, such as warranty expense and bad debt expenses, which are generally deferred until incurred for tax purposes but estimated and expensed for GAAP in the year of the corresponding sale.

There are situations other than timing differences where a difference in accounting between GAAP and tax causes a difference in the asset's basis that, like timing differences, tend to even out, or reverse, over time or when the asset is sold. For example:

  • The investment tax credit (ITC) provides a tax credit for certain investment expenses but requires a percentage reduction in the cost basis of the related asset for tax, creating a difference between GAAP basis (full cost) and tax basis (full cost less a percentage of the investment tax credit). ''The ITC,'' you mention, ''was the issue that first raised the interperiod tax allocation issue.''
  • Business combinations and certain transactions involving partnerships in which basis is stepped up from cost to fair market value (FMV) for GAAP purposes but is not stepped up for tax.

These are also characterized as temporary differences under the current guidance. These differences affect multiple years as the basis difference plays out through the amount, and perhaps timing, of depreciation and/or gain on sale.

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