Timing Differences

timing difference

For example, if a business buys a piece of equipment for $10,000 with a useful life of five years, the depreciation-expense the CPA deducts $2,000 each year for five years on the company’s financial statements. If the CPA uses an accelerated depreciation method on the tax return, the first-year depreciation expense may be $3,500 on the tax return and smaller amounts on each tax return over the remaining four years. These temporary differences are resolved, or reversed, at the end of the five-year period when the equipment is fully depreciated on both the financial statements and tax returns. Accrual accounting will only allow revenue to be recorded when it is earned, but if a company receives an advance payment of rental income, it must report this under taxable income on its tax return.

These are future taxable temporary differences because future periods’ taxable income will exceed GAAP income as the differences reverse; thus they give rise to deferred income tax liabilities. The computation of taxable income for the purpose of filing income tax returns differs from the computation of net income under GAAP for a variety of reasons. In some instances, referred to as temporary differences, the timing of income or expense recognition varies. In other instances, referred to as permanent differences, income or expense recognized for income tax purposes is never recognized under GAAP, or vice versa. An objective under GAAP is to recognize the income tax effects of transactions in the period that those transactions occur.

Under certain circumstances, the amounts assignable to assets or liabilities acquired in business combinations will differ from their income tax bases. Such differences may be either taxable or deductible in the future and, accordingly, may give rise to deferred income tax liabilities or assets.

timing difference

A temporary difference is expected to reverse in the future and therefore results in the creation of a DTL or DTA. The following are some examples of temporary differences and DTL/DTA created. Timing difference is the concept of the accounting that occurs due to the transition problems.

What is timing difference in deferred tax?

Timing difference is the concept of the accounting that occurs due to the transition problems. The timing difference is the term that is extremely used in the financial reporting or taxation purposes. The method of calculation of the depreciation is different in both financial accounting and taxation.

One results in a future taxable amount, such as revenue earned for financial accounting purposes but deferred for tax accounting purposes. This may happen if a company uses the cash method for tax preparation. A temporary difference results when a revenue (gain) or expense (loss) enters book income in one period but affects taxable income in a different (earlier or later) period.

– Certain estimated expenses, such as warranty costs, as well as such contingent losses as accruals of litigation expenses, are not tax deductible until the obligation becomes fixed. In those future periods, those expenses will give rise to deductions on the reporting entity’s income tax return. Thus, these are future deductible temporary differences that give rise to deferred income tax assets. Temporary differences include all the items formerly defined as timing differences, and other additional items.

Over the life of an asset, the value of the depreciation in both areas changes. At the end of the life of the asset, no deferred tax liability exists, as the total depreciation between the two methods is equal. The most common situation that generates a deferred income tax liability is from differences in depreciation methods. GAAP guidelines allow businesses to choose between multiple depreciation practices. However, the IRS requires the use of a depreciation method that is different from all the available GAAP methods.

But the tax will not actually be paid until the next calendar year. In order to rectify the accrual/cash timing difference is to record the tax as a deferred tax liability. Large corporations (assets of $10 million or more) are required to disclose their permanent and temporary book-tax differences on Schedule M-3 to their tax return. Second, the distinction is useful for those responsible for computing and tracking book-tax differences for tax return purposes and for calculating the income tax expense and effective tax rate to be reported in the financial statements. The differences in the timing of recognition of certain expenses and revenues for income tax reporting purposes versus the timing under GAAP had always been a subject for debates in the accounting profession.

The depreciation expense for long-lived assets for financial statements purposes is typically calculated using a straight-line method, while tax regulations allow companies to use an accelerated depreciation method. Since the straight-line method produces lower depreciation when compared to that of the under accelerated method, a company’s accounting income is temporarily higher than its taxable income. Temporary differences between the reporting of a revenue or expense for financial statements (books) and the reporting of the item for income tax purposes.

For example, it is common for companies to depreciate equipment on the financial statements over a ten-year period using the straight-line method. However, for income tax purposes the company uses the IRS’s seven-year, accelerated depreciation method. Eventually, the total depreciation will be the same; however, each year for ten years there will be differences due to the timing of the depreciation. The term “timing differences”, used under prior GAAP, has been superseded by the broader term “temporary differences” under current rules.

Consequently, deferred income tax benefits and obligations frequently arise in financial statements. A common source of deferred tax liability is the difference in depreciation expense treatment by tax laws and accounting rules.

Deferred tax liability is a tax that is assessed or is due for the current period but has not yet been paid. The deferral comes from the difference in timing between when the tax is accrued and when the tax is paid. A deferred tax liability records the fact the company will, in the future, pay more income tax because of a transaction that took place during the current period, such as an installment sale receivable.

  • These are future taxable temporary differences because future periods’ taxable income will exceed GAAP income as the differences reverse; thus they give rise to deferred income tax liabilities.
  • The computation of taxable income for the purpose of filing income tax returns differs from the computation of net income under GAAP for a variety of reasons.

The timing difference is the term that is extremely used in the financial reporting or taxation purposes. The method of calculation of the depreciation is different in both financial accounting and taxation. While the company is using the straight-line method for the depreciation, the tax authorities will use the accelerated depreciation method. This will cause the timing difference in the tax liability of the company even though the depreciation calculated by both methods is the same and the time period for the depreciation is also the same. For this reason, the amount of depreciation recorded on a financial statement is usually different than the calculations found on a company’s tax return.

Some of these differences are temporary, or timing differences, while others are permanent. The company recognizes the deferred tax liability on the differential between its accounting earnings before taxes and taxable income. As the company continues depreciating its assets, the difference between straight-line depreciation and accelerated depreciation narrows, and the amount of deferred tax liability is gradually removed through a series of offsetting accounting entries.

timing differences definition

Another common source of deferred tax liability is an installment sale, which is the revenue recognized when a company sells its products on credit to be paid off in equal amounts in the future. Under accounting rules, the company is allowed to recognize full income from the installment sale of general merchandise, while tax laws require companies to recognize the income when installment payments are made. This creates a temporary positive difference between the company’s accounting earnings and taxable income, as well as a deferred tax liability.

Permanent book-tax differences arise from items that are income or deductions during the year for either book purposes or for tax purposes but not both. Permanent differences do not reverse over time, so over the long run the total amount of income or deductions for the items is different for book and tax purposes. Temporary book-tax differences arise because the income or deduction items are included in financial accounting income in one year and in taxable income in a different year. The amount of tax expense and tax liability noted in a company’s income statement and balance sheet (respectively) is based on book income, plus or minus any permanent differences. Certain business combinations accounted for by the purchase method or the acquisition method.

Upon reversal in the future, the effect would be to increase taxable income without a corresponding increase in GAAP income. Therefore, these items are future taxable temporary differences, and give rise to deferred income tax liabilities. – Certain taxable revenue received in advance, such as prepaid rental income and service contract revenue not recognized in the financial statements until later periods. These are future deductible temporary differences, because the costs of future performance will be deductible in the future years when incurred without being reduced by the amount of revenue deferred for GAAP purposes.

Officers’ life insurance premium payments and proceeds also are examples of permanent differences between the financial statements and tax returns. The premiums are recognized in the financial statements as business expenses but are not deductible on the income tax return. If an officer of the company dies and the proceeds are paid to the business, the CPA records the amount as income to the business on the financial statements. However, because the premiums are not recognized as expenses on the tax returns, the CPA does not include the proceeds as income on the tax returns. Permanent differences can arise when expenses recognized on the financial statements will never be deductible on the income tax returns.

As such, this revenue will be recorded on the tax return but not the book income. At a future period when the rental revenue is finally earned, the company will record that revenue under book income but not on its tax return, thereby reversing and eliminating the initial difference. Temporary differences occur because financial accounting and tax accounting rules are somewhat inconsistent when determining when to record some items of revenue and expense. Because of these inconsistencies, a company may have revenue and expense transactions in book income for 2013 but in taxable income for 2012, or vice versa.

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For example, if a business receives a prepayment for work not completed by the balance sheet date, the prepayment is not recognized as revenue on the financial statement balance sheet. However, since the payment has been received, the CPA must include it as income on the tax return, creating a temporary difference between financial statement income and tax return income. Unpaid expenses are included by the CPA on the financial statements as accrued expenses but not on the tax return as tax deductions until they have been paid. For example, a company that earned net income for the year knows it will have to pay corporate income taxes. Because the tax liability applies to the current year, it must also reflect an expense for the same period.

These differences are explicitly recognized by the reporting of deferred income taxes in the consolidated financial statements of the acquiring entity. Note that these differences are no longer allocable to the financial reporting bases of the underlying assets or liabilities themselves, as was the case under the old net of tax method. Increases in the income tax bases of assets resulting from the indexing of asset costs for the effects of inflation.

Consequently, the income tax benefit to be realized in future years from deducting those future costs is a deferred income tax asset. Temporary differences arise when business income or expenses are recognized in different periods on the financial statements than on the tax returns. These differences might include revenue recognition, expenses incurred but not yet paid or depreciation calculation differences.

Examples of Deferred Tax Liability Sources

For example, tax penalties on underpaid taxes and fines resulting from a violation of the law are recognized as expenses on the financial statements but are not deductible expenses on the tax return. With certain start-up costs, such as the cost of raising capital for a new business, the CPS enters them as expenses on the financial statements but he cannot deduct them on the tax return. Business entertainment and meal expenses are fully deductible on the financial statements, but the CPA can use only 50 percent of these expenses as allowable deductions on the tax return. Certified public accountants, or CPAs, are required to prepare business financial statements on the accrual basis in accordance with the generally accepted accounting principles. This requirement sometimes creates differences between the financial statements and business income tax returns.

The initial debate was over the fundamental principle of whether or not income tax effects of timing difference should be recognized in the financial statements. On the business financial statements, the CPA deducts depreciation expense in equal amounts each year over the useful life of the asset being depreciated. Tax law allows for different depreciation methods on the tax returns that can accelerate depreciation in the earlier years of an asset’s life.

Author: Anfisa Dmitrieva

Anfisa is a talented entrepreneur and business trainer in financial analytics and currency trading. In this blog she talks about accounting services, payroll calculation, investment consulting, tax training and much more.

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