CFA Level I Exam · Analysis of Income Taxes

Temporary vs Permanent Differences in Income Taxes

Updated 7 October 2026 · Fact-checked

A temporary difference arises when an item's carrying amount and tax base differ and the gap reverses over time, so it creates deferred tax. A permanent difference never reverses, so it creates no deferred tax and only moves the effective tax rate away from the statutory rate.

Understand Temporary vs Permanent Differences

Companies keep two sets of books. Financial statements follow IFRS and report accounting profit. The tax return follows tax law and reports taxable income. The two often differ.

Some differences are only about timing. The same total income or expense is recognised in both sets of books, but in different periods. Depreciation is the classic case. Accounting may use straight-line while tax allows faster write-offs. Early on, tax depreciation is higher, so taxable income is lower than accounting profit. Later the gap reverses. These are temporary differences. Under IFRS (IAS 12) they are measured by comparing an asset's or liability's carrying amount with its tax base, and they create deferred tax assets or liabilities.

Other differences never reverse. An item is either recognised in one set of books only, or it is never taxed or never deductible. Examples: fines and penalties that tax law does not allow as a deduction, interest income on certain government bonds that is exempt from tax, and certain non-deductible entertainment costs. These are permanent differences. No deferred tax is recorded. Instead they change the effective tax rate: income tax expense ÷ pre-tax income will differ from the statutory rate.

Temporary differences come in two types. A taxable temporary difference will produce taxable amounts in future periods when the asset is recovered or the liability settled. It gives a deferred tax liability. A deductible temporary difference will produce deductible amounts in future periods. It gives a deferred tax asset.

The exam tests whether you can classify an item and state its effect on deferred tax and on the effective tax rate.

Key formulas to remember

Temporary difference for an asset: Temporary difference = Carrying amount − Tax base; Positive for an asset means a taxable temporary difference (deferred tax liability). Negative means deductible (deferred tax asset).
Temporary difference for a liability: Temporary difference = Tax base − Carrying amount; The order is reversed so the signs match the asset formula: positive means taxable (deferred tax liability); negative means deductible (deferred tax asset). A liability with carrying amount above tax base gives a negative result, which is a deductible difference.
Deferred tax amount: Deferred tax = Temporary difference × Enacted tax rate; Use the rate expected to apply when the difference reverses, based on enacted or substantively enacted law.
Effective tax rate: Effective tax rate = Income tax expense ÷ Pre-tax income; Permanent differences push this away from the statutory rate. Temporary differences do not, because deferred tax is included in tax expense.
Classification rule: Reverses = temporary (deferred tax). Never reverses = permanent (no deferred tax).; Permanent items affect only the effective rate.

How to solve Temporary vs Permanent Differences questions

Use this sequence for any question on classifying differences or their effects.

1Identify the item and ask: will the gap between accounting and tax reverse in a later period?
2If it reverses, label it temporary. If it never reverses, label it permanent.
3For a temporary item, find the carrying amount and the tax base.
4For an asset, carrying amount above tax base is taxable (deferred tax liability). Carrying amount below tax base is deductible (deferred tax asset).
5For a liability, carrying amount above tax base is deductible (deferred tax asset). Carrying amount below tax base is taxable (deferred tax liability).
6Multiply the difference by the enacted tax rate to get the deferred tax balance.
7For a permanent item, record no deferred tax. Compute the tax effect only for the effective tax rate.
8Check the answer against the question: deferred tax, taxes payable, or effective rate.

Quickest way: Reverse or not: the two-second test

When to use it: Use when the question asks you to classify an item or pick the effect on deferred tax or the effective rate.

Ask: will this ever reverse? Yes means temporary, no means permanent.
Permanent: no deferred tax, effective rate differs from statutory.
Temporary on an asset: carrying amount above tax base means deferred tax liability.
Temporary on a liability: carrying amount above tax base means deferred tax asset.
Eliminate options that put a permanent item on the balance sheet as deferred tax.

Common mistakes in Temporary vs Permanent Differences

Recording deferred tax on a permanent difference.
Any gap between accounting profit and taxable income looks like it needs a deferred tax entry.
Fix: Only reversing differences create deferred tax. Permanent items change the effective tax rate only.
Reversing the rule for liabilities.
Students memorise the asset rule and apply it unchanged to liabilities.
Fix: For a liability, carrying amount above tax base is deductible and gives a deferred tax asset. Example: a warranty provision not yet deductible for tax.
Thinking temporary differences change the effective tax rate.
Taxes payable differ from the statutory rate times pre-tax income, so the rate seems affected.
Fix: Tax expense includes the deferred part, so temporary differences do not by themselves cause the effective rate to differ from the statutory rate. Permanent differences move it.
Treating tax-exempt income as temporary.
It is a difference between profit and taxable income, and students assume all such differences reverse.
Fix: Income that is never taxed will never produce a future taxable amount, so it is permanent.
Using the wrong tax rate for deferred tax.
Students use the current rate by habit.
Fix: Use the enacted or substantively enacted rate expected to apply when the difference reverses. If the question gives a future rate, use it.

Worked examples

Example 1

A company buys equipment for $100,000. For accounting it depreciates straight-line over 5 years with no residual value. Tax law allows a deduction of $40,000 in year 1. The tax rate is 30%. At the end of year 1, what deferred tax liability does the company report? Choose: A) $3,000, B) $6,000, C) $18,000.

Show the solution

Carrying amount = 100,000 − 20,000 = 80,000.
Tax base = 100,000 − 40,000 = 60,000.
Carrying amount exceeds tax base by 20,000 on an asset, so it is a taxable temporary difference.
Deferred tax liability = 20,000 × 30% = 6,000.
Option C results from applying the 30% rate to the tax base (60,000 × 30% = 18,000) instead of to the 20,000 difference. Option A applies the rate to only half of the difference (10,000 × 30% = 3,000).

Answer: B) $6,000. The carrying amount is 80,000 and the tax base is 60,000. The 20,000 difference is a temporary, taxable difference, so it gives a deferred tax liability.

Example 2

A company has pre-tax income of €500,000 and a statutory tax rate of 25%. Included in expenses is a fine of €40,000 that tax law does not allow as a deduction. There are no other differences. What is the income tax expense and the effective tax rate? Choose: A) €125,000 and 25.0%, B) €135,000 and 27.0%, C) €145,000 and 29.0%.

Show the solution

The fine is a permanent difference. It never reverses, so there is no deferred tax.
Taxable income = 500,000 + 40,000 = 540,000.
Tax expense = 540,000 × 25% = 135,000.
Effective rate = 135,000 ÷ 500,000 = 27.0%.
Option A ignores the fine. Option C adds the fine twice.

Answer: B) €135,000 and 27.0%. The permanent difference raises the effective rate above the 25% statutory rate.

Exam tips

Start every question with the reverse-or-not test. It removes one or two options quickly.
Memorise permanent examples: non-deductible fines, tax-exempt interest, and similar items that are never taxed or never deducted.
For liabilities, flip the asset logic. Watch for provisions and accrued expenses that are deducted only when paid.
If the question asks about the effective tax rate, check for permanent differences first. Temporary ones leave it unchanged.
Read whether the question wants the deferred tax balance or the taxes payable. They are different numbers.

Practice questions from Analysis of Income Taxes

Temporary vs Permanent Differences in other exams

The same ground in other exams, if you are preparing for more than one or want another angle on it.

Temporary vs Permanent Differences: frequently asked questions

What is the difference between temporary and permanent differences?

A temporary difference reverses over time and creates a deferred tax asset or liability. A permanent difference never reverses, so it creates no deferred tax. It only changes the effective tax rate.

What is a taxable versus a deductible temporary difference?

A taxable temporary difference leads to taxable amounts in future periods and creates a deferred tax liability. A deductible temporary difference leads to deductible amounts in future periods and creates a deferred tax asset.

Give examples of permanent differences.

Common examples are fines that are not tax deductible, interest income that is exempt from tax, and costs that tax law never allows as a deduction. None of them reverses, so none creates deferred tax.

Do permanent differences affect the effective tax rate?

Yes. They make income tax expense divided by pre-tax income differ from the statutory rate. Temporary differences do not, because deferred tax is part of the tax expense.