The financial accounting term permanent differences typically refers to transactions that are recognized for financial reporting purposes but not for income tax purposes. Although less common, permanent differences can also refer to transactions that are recognized for income tax purposes, but not for financial reporting purposes.
When a permanent difference exists, the journal entries for the transactions will not affect deferred income tax.
Companies will typically have two sets of books: financial accounting (book) and income tax. A difference occurs when the calculation of net income for accounting purposes varies from that determined for income tax purposes.
Permanent differences can occur for a number of reasons; although most differences are temporary in nature and are referred to as timing differences. While a timing difference involves reversing entries that will eventually account for the variance between the two sets of books, permanent differences do not require future journal entries to reverse the variance.
Examples of permanent differences are shown below:
- Depletion: includes depletion costs associated with natural resources. Unlike depreciation expense, which can cause a temporary difference between income tax and financial reporting, there is oftentimes a difference between the cost depletion and percentage depletion that does not reverse itself over time.
- Dividends Received: includes those received from another company. Companies will record 100% of these dividends as income for book purposes. If the ownership is less than 20% of the investee's shares outstanding, then 70% of the income is not taxable. If ownership is between 20 and 80%, then 80% of the income is not taxable. If ownership is over 80%, then 100% of the dividends received are not taxable.
- Fines and Penalties: includes expenses associated with violations of civil and criminal law. Companies can deduct these costs for book purposes, but they are not tax deductible.
- Government Bonds: includes interest income received from investments in bonds of state and municipal governments. Companies can include this income for book purposes, but they are not taxable.
- Life Insurance Premiums: includes premiums paid for employee life insurance policies when the company is the beneficiary. Companies can deduct these costs for book purposes, but they are not tax deductible.
- Life Insurance Proceeds: includes money received by a company upon the death of an insured executive. Companies can include these proceeds for book purposes, but they are not taxable.
- Meals and Entertainment: includes expenses associated with providing employees with business related costs such as meals and entertainment while traveling. Companies can deduct these costs for book purposes, but only 50% of these costs are tax deductible.
- Stock Options: includes employee compensation related to some forms of stock option plans. Companies can deduct these costs for book purposes, but they are not always tax deductible.
- Tax-Exempt Income: includes those expenses associated with purchasing securities that result in tax-exempt income. Companies can deduct these costs for book purposes, but they are not tax deductible.
timing differences, originating and reversing differences, gross change method, net change method