Hi everyone. In this lesson, we will examine some examples of permanent versus temporary differences. Let's take a look. First, we are asked to prepare a reconciliation between pre-tax gap income and taxable income. Here we have Illini Inc. that's reported pre-tax accounting income of $700,000 for 2022. The following information relates to differences between pre-tax gap income and taxable income.
Now we'll see some of these examples of these different types of differences. For number one, during 2022, the company earns $15,000 of interest revenue for municipal bonds. Interest income on municipal bonds is not subject to income taxes.
So to get us started with our reconciliation, we'll begin with our pre-tax accounting income and we'll add our first item. Here we have this permanent difference related to interest on municipal bonds. This represents income that would be part of our pre-tax accounting income, but is not taxable.
So we are reducing that 15 from our accounting income. And our end goal is to reach taxable income for our tax return. For number two, on January 1, 2022, the company purchased equipment for $72,000 that has a four-year estimated useful life and a salvage value of zero. The company uses straight-line depreciation for financial reporting, so $18,000 per year, but tax rules allow the full cost of the equipment to be deducted on the 2022 tax return.
So this is telling us that during 2022, $72,000 would be deducted for tax purposes. While for financial reporting purposes, we would only be deducting one year of depreciation expense, or $18,000. So, on our reconciliation, we'll add a new section for temporary differences. And here we see an adjustment for the difference between our book depreciation and our tax depreciation.
Notice that we are reducing pre-tax accounting income by 54. because this represents the additional depreciation that's allowed under tax reporting. And for number three, during 2022, the company earned $80,000 from installment sales of property. The installment sales are recognized as income for financial reporting purposes in 2022. However, they're reported on the tax return when collected in 2023 for $50,000.
and 2024 for $30,000. So here we have income that will be on our income statement, but not yet showing on the tax return. So in our reconciliation, we are going to be removing these installment sales of $80,000 for purposes of calculating taxable income. And number four, The company estimates its warranty liability related to 2022 product sales to be $16,000.
The warranty costs are accrued in 2022 for financial reporting purposes. For tax reporting, warranty costs are not deductible until paid in cash. This amount will be paid equally over the next two years. Well, here we have this accrued expense that would be included on the income statement.
but not yet deductible on the tax return. So for our reconciliation, here we're adding back these warranty costs because we cannot yet include them on the tax return. And number five, the company collected $102,000 during 2022 related to prepaid rent.
The $102,000 will be recognized as income for financial reporting purposes. during 2023 through 2025. For tax reporting, the $102,000 is taxable in the year of collection. So this $102,000 is not yet going to show on the income statement, but will be part of the tax return.
So in our reconciliation, we are going to be adding in these unearned revenues since they are taxable. And number six, the company was assessed a penalty of $20,000 by the Environmental Protection Agency for violation of federal law in January 2022. The fine was paid in full later in the year. Well, here we do have an additional permanent difference that relates to this EPA penalty. So this penalty would have been deducted for purposes of calculating our pre-tax accounting income, but it cannot be deducted for tax purposes.
So we are adding it back for purposes of calculating taxable income. All right, and the last step for our reconciliation is to find our taxable income, so the amount of income that would show on the tax return. So now that we've finished our reconciliation, we can see that we have these two categories for those differences that are permanent.
meaning they will not reverse in a future period, and those differences that are temporary, meaning they will reverse or offset in the future. I hope this has been helpful as we talk through these examples. Thank you for joining.
We'll see you next time.