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Lesson 1.2 Ex: Permanent and Temporary Differences Demonstration

Mar 19, 2025

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.