Originating and Reversing Differences

Definition

The financial accounting terms originating and reversing differences refer to the initial timing variance between pretax accounting income and taxable income, and the elimination of those variances.  Originating and reversing entries are needed due to timing differences, which occur when revenues and expenses are included in the calculation of accounting income in one period, while their impact to taxable income is reported in a different period.

Explanation

Companies typically have two sets of books:  financial accounting and income tax.  Timing differences can occur for a number of reasons, and while they can be permanent, most are temporary in nature.  A timing difference will occur when the calculation of pretax net income for accounting purposes (book) varies from that determined for income tax purposes.  When a timing difference is temporary in nature, companies will make both originating and reversing entries to smooth out those variances over time:

  • Originating Difference:  includes the initial timing difference between pretax accounting income and taxable income.  This could include both credit and debit entries to deferred income taxes.
  • Reversing Difference:  includes those journal entries required to eliminate the impact timing differences had on deferred income taxes in prior periods.

For example, a company might choose to use straight line depreciation in its financial statements and the Modified Accelerated Cost Recovery System (MACRS) for income tax reporting.  In this example, the difference between the two methods is eventually reversed using a deferred income tax account.

Example

Company A's pretax accounting income over the last four years was $10,000,000.  In Year 1, Company A sold $600,000 in transformers on installment, payable in Years 2 through 4.  Company A's pretax accounting income and taxable income appears in the table below.  Company A's tax rate is 40%.

  Year 1 Year 2 Year 3 Year 4
Pretax Accounting Income $10,000,000 $10,000,000 $10,000,000 $10,000,000
Timing Difference, Installment Sales        
   Originating Difference -$600,000      
   Reversing Difference   $200,000 $200,000 $200,000
Taxable Income $9,400,000 $10,200,000 $10,200,000 $10,200,000
Income Taxes Payable (40% Tax Rate) $3,760,000 $4,080,000 $4,080,000 $4,080,000

The originating journal entry to account for the above timing difference would be as follows.  For all four years, the accounting income tax expense would be $10,000,000 x 40%, or $4,000,000.  Since the income taxes payable in Year 1 are $3,760,000, a credit of $240,000 to deferred income tax is required.

  Debit Credit
Income Tax Expense $4,000,000  
Deferred Income Tax   $240,000
Income Taxes Payable   $3,760,000

In Years 2 through 4, reversing journal entries are needed to eliminate the balance in the deferred income tax account by $240,000 / 3, or $80,000 annually.

  Debit Credit
Income Tax Expense $4,000,000  
Deferred Income Tax $80,000  
Income Taxes Payable   $4,080,000

Related Terms

timing differencespermanent differences, gross change method, net change method