Temporary Difference
Overview
Temporary difference is the difference between the value of an asset or liability in the balance sheet following the accounting base and its tax base. Likewise, a temporary difference will make the net income (before tax) in the accounting base different from taxable income following the tax base.
As a result, it creates deferred tax, which could be deferred tax asset or deferred tax liability. However, this difference will be net off or settled in the future period.
In other words, the value of an asset or liability in the accounting base and tax base will be the same if we total their value in all periods. So, the difference is the timing of recognition; hence, the word “temporary”.
Types of temporary difference
Temporary difference can be either a taxable temporary difference or a deductible temporary difference.
Taxable temporary difference
Taxable temporary difference is the timing difference that creates tax liability which the company needs to pay in the future. In other words, the taxable temporary difference creates deferred tax liability.
We will have a taxable temporary difference when:
- carrying value of an asset in the accounting base is bigger than its tax base, or
- carrying value of liability in accounting base is smaller than its tax base
Deductible temporary difference
Deductible temporary difference is the timing difference that creates tax asset which the company can deduct in the future. In other words, deductible temporary difference creates deferred tax asset.
We will have a deductible temporary difference when:
- carrying value of an asset in the accounting base is smaller than its tax base, or
- carrying value of liability in accounting base is bigger than its tax base
Temporary difference examples
Example of temporary difference for deferred revenue
For example, in 2019, ABC Internet Co. received $10,000 from its clients in advance for two years of internet service in 2020 and 2021.
The company recognized it as deferred revenues in 2019 and will recognize it as revenues equally in 2020 and 2021 in the accounting base. However, as the company received cash in 2019, all $10,000 was recognized as revenues in 2019 in the tax base.
Calculate the temporary difference in 2019, and determine whether it is a taxable temporary difference or deductible temporary difference.
Solution:
With the example, it will create a temporary difference as below:
| Balance sheet | Year | 2019 | 2020 | 2021 | Total |
|---|---|---|---|---|---|
| Deferred revenues | Accounting base | 10,000 | (5,000) | (5,000) | – |
| Tax base | – | – | – | – |
| Income statement | Year | 2019 | 2020 | 2021 | Total |
|---|---|---|---|---|---|
| Revenues | Accounting base | – | 5,000 | 5,000 | 10,000 |
| Tax base | 10,000 | – | – | 10,000 |
In 2019, the company recognized deferred revenues $10,000 in the accounting base but $0 in the tax base. Hence, we can calculate the temporary difference for deferred revenue in 2019 as below:
Temporary difference = 10,000 – 0 = 10,000
In this case, the deferred revenue in the accounting base is bigger than its tax base. And as deferred revenue is a liability, the temporary difference, in this case, is the deductible temporary difference.
Example of temporary difference for depreciation
For example, in Jan 2019, ABC Co. bought a truck that cost $20,000 to use in the company. The company depreciated the truck with a useful life of 5 years using the straight-line depreciation method in the accounting base.
However, in the tax base, the truck needs to be depreciated using the declining balance with a rate of 35% per annum.
Calculate the temporary difference in 2019 and determine the type of temporary difference.
Solution:
With the example, the difference between the accounting base and tax base for depreciation and the carrying value of the truck will create temporary difference as below:
| Accounting base | Tax Base | |
|---|---|---|
| Depreciation | 20,000 / 5 = 4,000 | 20,000 * 35% = 7,000 |
| Carrying value of truck (NBV) | 20,000 – 4,000 = 16,000 | 20,000 – 7,000 = 13,000 |
So, the carrying value of the truck is $16,000 in the accounting base but its tax-based value is $13,000. In this case, we can calculate the temporary difference for depreciation in 2019 as below:
Temporary difference = 16,000 – 13,000 = 3,000
The truck is an asset; and as its carrying value in the accounting base is bigger than the tax base, the type of temporary difference, in this case, is the taxable temporary difference.
Temporary difference and permanent difference
While the temporary difference is just a timing difference, the permanent difference is the result of different treatment of income or expense in the accounting base and tax base. In this case, the permanent difference will never be reversed back or settled in the future like those of temporary difference.
We have a permanent difference when there is a non-taxable income or non-deductible expense. In this case, non-taxable income is the income that exempts from tax; and non-deductible expense is the expense that cannot deduct from taxable income.
For example, the interest income from government bonds which the company invests in is usually a non-taxable income. On the other hand, the entertainment expense, fine and expense from violation of the law, or expense that has no proper invoices are usually non-deductible expenses. In this case, we will have permanent difference if we have these types of income or expenses in the company.
