Timing Differences

Definition

The financial accounting term timing differences refers to variances between what a company reports in its financial statements and income tax returns.  Timing differences can occur when revenues and expenses are included in the calculation of accounting income in one period, while their impact on taxable income is reported in a different period.

Explanation

Timing differences can occur for a number of reasons, and while they can be permanent, most are temporary in nature.  Companies typically have two sets of books:  financial accounting and income tax.  A timing difference will occur when the calculation of net income for accounting purposes varies from that determined for income tax purposes.  Timing differences are temporary in nature and journal entries are used to reverse the difference over time.

The most often cited example of this difference has to do with depreciation expense; whereby a company might choose to use straight line depreciation on 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 reconciled using a deferred income tax account.

Additional examples of methods and approaches that can result in timing differences for revenues and expenses include:

  • Revenues:  installment sales, long-term projects using the percentage-of-completion method, stock investments using the equity method, accrual versus cash methods, and advanced collections.
  • Expenses:  depreciation, serviceable lives of assets, guarantee and warranty cost estimates, bad debt expense, contingent liabilities such as the estimated losses associated with pending lawsuits, and discontinued operations.

Example

Company A's pretax accounting income over the last three years was $10,000,000.  In Year 1, Company A sold $1,000,000 in transformers on installment, payable in both Year 2 and Year 3 at $500,000 annually.  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
Pretax Accounting Income $10,000,000 $10,000,000 $10,000,000
Timing Difference, Installment Sales      
   Originating Difference -$1,000,000    
   Reversing Difference   $500,000 $500,000
Taxable Income $9,000,000 $10,500,000 $10,500,000
Income Taxes Payable (40% Tax Rate) $3,600,000 $4,200,000 $4,200,000

The journal entries to account for the above timing difference would be as follows.  For all three 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 $3,600,000, a credit of $400,000 to deferred income tax is required.

  Debit Credit
Income Tax Expense $4,000,000  
Deferred Income Tax   $400,000
Income Taxes Payable   $3,600,000

In Year 2, a journal entry is needed to begin the process of lowering the balance in the deferred income tax account.

  Debit Credit
Income Tax Expense $4,000,000  
Deferred Income Tax $200,000  
Income Taxes Payable   $4,200,000

In Year 3, the same entries are needed to complete the transaction.

  Debit Credit
Income Tax Expense $4,000,000  
Deferred Income Tax $200,000  
Income Taxes Payable   $4,200,000

Related Terms

permanent differences, originating and reversing differences, gross change method, net change method