In accounting, the phrase temporary differences typically refers to the differences between the recorded amounts of assets and liabilities, in accordance with the historical cost principle and the amounts that will be recorded, according to the true economic position, as determined by the principles of accrual accounting, or a similar fiscal reporting system that most countries have adopted. This difference can be explained as the gap between the companys book value and tax value.
When an entity has a situation in which the accounting value is different from the tax value reported in the income statement or balance sheet, this is considered a temporary difference. Temporary differences can occur in the depreciable assets (land, plant, equipment, building), inventory, unrecognized liabilities, accumulated provisions, and income types such as pension plans, deferred payment of sales, tax credits, and employee stock options. In addition to permanent differences like bad debts and unrealized inter-company receivables.
Under the accrual method of accounting, a company can record revenues and expenses before they are actually received or paid. Therefore, when temporary differences exist, there are likely to be taxable incomes that are different from the financial income that has been recorded.
Most countries have regulations in place that require companies to recognizes these deferred taxation assets or liabilities. In some countries, companies recognize deferred tax relating to temporary differences between the carrying amount of an asset or liability in the financial statements and its tax base. Deferred tax arising as a result of these differences are recognized as a liability or asset.
This is called deferred tax liability and it occurs when the impact of the temporary difference is expected to be tax deductible in future years. On the other hand, deferred tax asset occurs when the impact of the temporary difference is expected to be taxed in future years and it is recognized when the entity has the taxable income and it is reasonably certain that sufficient taxable income will be available against which the deferred tax asset can be utilized.
For example, let’s assume that ABC company purchased some machinery for $50,000 in year 1 and recorded it on the balance sheet with full depreciation for this amount as $50,000. This amount will affect the financial statements and will be recorded on the balance sheet as an asset with zero book value.
However, for the tax purpose, the actual value of the machine will not be taken into account when calculating the taxes for year 1. Instead, the tax regulations in this case would allow ABC company to depreciate (for the tax purpose) the machine over 5 consecutive years with the amount of $10,000 deducted each year.
Therefore, ABC company has a temporary difference of $40,000 on the balance sheet in year 1 (i.e., the difference between the book value of $50,000 and the tax value of $10,000). This $40,000 of difference will be added to its taxable income of the future years when calculating taxes. This deferred tax will create an asset on ABC companys balance sheet (deferred tax asset).
In summary, in accounting, temporary differences refer to a discrepancy between the amount reported on the income statement or balance sheet for accounting purposes and for tax purposes. This discrepancy can create assets or liabilities for deferred tax. Deferred tax assets or liabilities are reported in the balance sheet, and companies need to recognize these assets or liabilities in order to report their true economic position.
