Lecture Notes: Permanent vs. Temporary Differences

Introduction

• Topic: Differences between pre-tax GAAP income and taxable income.
• Focus on examples of permanent and temporary differences in financial reporting.

Key Concepts

• Permanent Differences: Do not reverse in the future.
• Temporary Differences: Reverse or offset in future periods.

Illini Inc. Example

• Pre-tax Accounting Income for 2022: $700,000
• Objective: Prepare reconciliation between pre-tax GAAP income and taxable income.

Examples of Differences

1. Interest Revenue from Municipal Bonds

• Amount: $15,000
• Nature: Permanent difference (not taxable).
• Action: Subtract from pre-tax accounting income.

2. Equipment Purchase and Depreciation

• Cost: $72,000
• Financial Reporting Depreciation: Straight-line, $18,000/year.
• Tax Reporting: Full cost deducted in 2022.
• Nature: Temporary difference.
• Action: Reduce pre-tax accounting income by $54,000 (difference between book and tax depreciation).

3. Installment Sales

• Amount: $80,000
• Recognition:
  • Financial Reporting: 2022
  • Tax Reporting: $50,000 in 2023; $30,000 in 2024.
• Nature: Temporary difference.
• Action: Remove $80,000 for taxable income calculation.

4. Warranty Liability

• Amount: $16,000
• Recognition:
  • Financial Reporting: Accrued in 2022.
  • Tax Reporting: Deductible when paid in future.
• Nature: Temporary difference.
• Action: Add back warranty costs as they are not deductible yet.

5. Prepaid Rent

• Amount: $102,000
• Recognition:
  • Financial Reporting: 2023-2025.
  • Tax Reporting: Taxed in 2022.
• Nature: Temporary difference.
• Action: Add unearned revenues to taxable income.

6. EPA Penalty

• Amount: $20,000
• Nature: Permanent difference.
• Action: Add back penalty as it cannot be deducted for tax purposes.

Conclusion

• Final Step: Determine taxable income for tax return.
• Differentiation between permanent and temporary differences is crucial for accurate financial and tax reporting.

Closing

• Importance of understanding these differences for financial analysis and tax compliance.
• Acknowledgment of the concepts discussed and their practical implications.