Temporary difference: Meaning, Criticisms & Real-World Uses

What Is Temporary Difference?

A temporary difference, in the context of accounting and taxation, refers to the discrepancy between the carrying amount (or book value) of an asset or liability on a company's balance sheet and its tax base. These differences arise because the rules for preparing financial statements, typically under Generally Accepted Accounting Principles (GAAP) or International Financial Reporting Standards (IFRS), often differ from the rules used to calculate taxable income for tax authorities. This aspect of financial reporting ensures that the tax implications of transactions are recognized in the same period as the transactions themselves, even if the actual tax payment or deduction occurs at a different time.

History and Origin

The concept of temporary differences became formalized with the evolution of income tax accounting standards, aiming to reconcile the differences between financial reporting and tax reporting. A significant development in U.S. GAAP was the issuance of Statement of Financial Accounting Standards (SFAS) No. 109, "Accounting for Income Taxes," in February 1992 by the Financial Accounting Standards Board (FASB). This standard, now codified primarily as ASC 740, required companies to recognize deferred tax liabilities and assets for the future tax consequences of events that had already been recognized in a company's financial statements or tax returns. Before SFAS 109, a more complex deferred method was used, but the balance sheet approach introduced by SFAS 109 provided a clearer framework for recognizing the future tax effects of these temporary discrepancies. The FASB (Financial Accounting Standards Board) issued Statement No. 109 in February 1992, which became effective for fiscal years beginning after December 15, 1992.⁴

Key Takeaways

A temporary difference is the disparity between an asset or liability's carrying amount on the balance sheet and its tax base.
These differences lead to the recognition of deferred tax assets or deferred tax liabilities.
They arise from timing variations in how revenue and expenses are recognized for accounting versus tax purposes.
Temporary differences are expected to reverse over time, affecting future taxable income.
Understanding temporary differences is crucial for accurate financial statement analysis and tax planning.

Formula and Calculation

While there isn't a single formula for "temporary difference" itself, it is the result of applying different rules for financial accounting and tax accounting. The temporary difference for a specific item is calculated as:

\text{Temporary Difference} = \text{Carrying Amount of Asset/Liability} - \text{Tax Base of Asset/Liability}

Alternatively, it can also be conceptualized as the cumulative difference between accounting profit and taxable income that will reverse in future periods.

For example, consider depreciation methods. For financial reporting, a company might use straight-line depreciation, while for tax purposes, it might use accelerated depreciation. This leads to:

Earlier periods: Tax depreciation > Accounting depreciation. This results in taxable income being lower than accounting profit, creating a deductible temporary difference and a deferred tax asset.
Later periods: Tax depreciation < Accounting depreciation. This results in taxable income being higher than accounting profit, creating a taxable temporary difference and a deferred tax liability.

Interpreting the Temporary Difference

Interpreting a temporary difference involves understanding its implications for a company's future tax obligations or benefits. A temporary difference indicates that the amount of tax expense recognized on the income statement in the current period differs from the actual income tax payable or refundable for that period.

When a company's accounting profit is greater than its taxable income due to timing differences, it results in a taxable temporary difference, which leads to a deferred tax liability. This signifies that the company will likely pay more taxes in the future when the temporary difference reverses. Conversely, when taxable income is greater than accounting profit, it creates a deductible temporary difference, giving rise to a deferred tax asset. This indicates that the company will receive a tax benefit in the future as the difference reverses, reducing future tax payments. Analysts examine these deferred tax balances to gain insight into a company's future cash flow implications related to taxes.

Hypothetical Example

Consider Company A, which purchased a machine for $100,000. For financial reporting (GAAP), Company A depreciates the machine using the straight-line method over 5 years, resulting in an annual depreciation expense of $20,000. For tax purposes, however, the tax authority allows accelerated depreciation, permitting a deduction of $40,000 in the first year.

In Year 1:

Accounting Depreciation: $20,000
Tax Depreciation: $40,000

The difference in depreciation creates a temporary difference. Since tax depreciation is higher than accounting depreciation, Company A's taxable income will be lower than its pre-tax income for financial reporting.

Temporary Difference (Year 1): $20,000 (Taxable Income < Accounting Profit)

This $20,000 temporary difference creates a deferred tax liability. This means that in future years, when accounting depreciation exceeds tax depreciation, the temporary difference will reverse, and Company A will pay more tax than its accounting profit suggests in those periods.

Practical Applications

Temporary differences are fundamental in various aspects of financial analysis and corporate finance:

Financial Statement Analysis: Investors and analysts scrutinize deferred tax assets and liabilities to understand the true underlying profitability and future cash flow implications of a company's operations. They help reconcile the current tax expense with the cash taxes paid or received.
Tax Planning and Compliance: Companies manage temporary differences to optimize their tax payments within legal frameworks. Awareness of these differences is critical for complying with tax regulations, such as those outlined by the IRS, which provides guidance on various accounting periods and methods for tax purposes.³
Mergers and Acquisitions (M&A): During M&A activities, assessing existing deferred tax assets and liabilities is vital for valuing target companies and understanding their future tax exposures or benefits.
Auditing: Auditors verify the accurate identification and measurement of temporary differences to ensure compliance with accounting standards and the fair presentation of financial statements.
International Reporting: For multinational corporations, navigating temporary differences becomes even more complex due to varying tax laws and accounting standards (e.g., U.S. GAAP versus IFRS) across different jurisdictions. International standards, like IAS 12 "Income Taxes," specifically address the accounting treatment for income taxes and temporary differences.²

Limitations and Criticisms

While temporary differences are crucial for accrual accounting and matching principles, their application can present challenges and criticisms:

Complexity: Calculating and tracking temporary differences, especially for complex multinational corporations with numerous assets and liabilities and varying tax jurisdictions, can be highly intricate. This complexity can make financial statements more difficult for external users to understand.
Estimation and Judgment: The recognition of deferred tax assets often relies on the judgment of future profitability against which these assets can be utilized. If a company fails to generate sufficient taxable income in the future, the value of its deferred tax assets may need to be written down through a valuation allowance, impacting current earnings. Concerns regarding the valuation of deferred tax assets, particularly for banks, have been highlighted by regulators like the European Central Bank.¹
Non-Cash Nature: Deferred tax assets and liabilities are non-cash items. While they reflect future cash flow effects, they do not represent immediate cash inflows or outflows, which can sometimes be misunderstood by those focused solely on current cash flows.
Impact of Tax Law Changes: Changes in tax rates or tax laws can significantly alter the value of existing deferred tax assets and liabilities, requiring re-measurement and potentially leading to volatility in the income statement.

Temporary Difference vs. Permanent Difference

Temporary differences are often contrasted with permanent differences.

Feature	Temporary Difference	Permanent Difference
Reversal	Reverses in future periods. It is a timing difference, meaning the revenue or expense is recognized for both accounting and tax purposes, but in different periods. Examples include differences in depreciation methods, warranty expenses, or installment sales. These give rise to deferred tax assets or deferred tax liabilities.	Does not reverse. It is a difference between accounting and tax income that will never be eliminated because an item of revenue or expense is recognized for either accounting or tax purposes, but not both. Examples include tax-exempt interest income, non-deductible fines and penalties, or the non-taxable portion of dividends received.
Future Impact	Affects future cash taxes when the difference reverses.	No future tax impact; the difference is permanent.
Balance Sheet	Creates a deferred tax asset or liability on the balance sheet to reflect the future tax consequences.	Does not create deferred tax assets or liabilities.

The key distinction lies in their reversal. Temporary differences are simply timing issues between accrual accounting for financial reporting and the specific rules for cash basis accounting or other permitted methods for tax purposes. Permanent differences, conversely, are items that are treated differently by accounting and tax rules, with no expectation of future reversal.

FAQs

What causes a temporary difference?

Temporary differences arise primarily from timing variations in recognizing income and expenses for financial reporting versus tax purposes. Common causes include using different depreciation methods, recognizing revenue for accounting when earned but for tax when received (revenue recognition), or differences in accounting for provisions and warranty expenses.

Are temporary differences good or bad for a company?

Temporary differences themselves are neither inherently good nor bad. They are a natural outcome of differing accounting and tax regulations. Their "goodness" or "badness" depends on whether they create a deferred tax asset (future tax savings) or a deferred tax liability (future tax payments), and the overall financial health and profitability of the company. A large deferred tax asset, for instance, is beneficial only if the company expects to generate sufficient future taxable income to utilize it.

How do temporary differences affect a company's financial statements?

Temporary differences primarily affect the balance sheet through the creation of deferred tax assets or deferred tax liabilities. They also impact the income statement by causing the current period's tax expense to differ from the actual taxes currently payable or refundable, ensuring that the tax effects are recognized in the same period as the related economic transactions.