Step 1 – Identifying Permanent and Temporary Differences
One of the first steps in calculating the income tax provision is to review financial and other company information to identify permanent and temporary differences between book income and taxable income.
Permanent differences arise from statutory provisions of the tax law that specify that certain revenues are exempt from taxation and certain expenses are not allowed as deductions in determining taxable income. Municipal bond interest income is an example of revenue that is exempt from federal taxation. Examples of deductions that are not allowed in determining taxable income are fines, penalties and meals and entertainment expenses. Also, tax credits are an example of tax benefit items that reduce income tax payable but are not an item shown on the financial statements. As a result, tax credits could be considered a permanent difference. Because permanent differences do not reverse in the future, the identified items will have a direct impact on total income tax expense.
In contrast, temporary differences will reverse in the future and there will be no impact to total income tax expense for any change in a temporary difference. Temporary differences are differences between the tax basis of an asset or liability and its reported amount in the financial statements. These differences will result in deductible or taxable amounts in future years when the reported amount on the financial statement is recovered and settled.
Temporary differences occur because the book and tax treatment of certain transactions are different – specifically the timing of their recognition. For example, the amount of depreciation expense from the purchase of a fixed asset will be the same over a period of time for both book and tax purposes. The amount of depreciation in any one year will be different depending upon the calculation method used and the life over which the asset is depreciated.
Temporary differences are typically identified by a review of the balance sheet. Temporary differences may also include attribute carryovers such as net operating loss carryover and tax credit carryover.
Both permanent and temporary differences are identified by performing a detailed review of the trial balance or general ledger of the company. A review of the company’s significant accounting policies should also be performed. The identification of new balance sheet and income statement accounts and the determination of the tax method of accounting for these items and corresponding difference from book treatment are particularly important. Additional steps for identifying differences are to review discrete transactions such as acquisitions or divestures that occurred during the year and to review prior year tax returns and income tax provisions for completeness and consistency of continuing differences.
For question regarding ASC-740 provision matters, please contact Daniel DeLau at 720-227-0065 or delau@taxops.com or John Monahan at 720-227-0064 or jmonahan@taxops.com.
