What is a Temporary Difference?

A temporary difference is the difference between the carrying amount of an asset or liability in the balance sheet and its tax base. A temporary difference can be either of the following:

Deductible. A deductible temporary difference is a temporary difference that will yield amounts that can be deducted in the future when determining taxable profit or loss.
Taxable. A taxable temporary difference is a temporary difference that will yield taxable amounts in the future when determining taxable profit or loss.

In both cases, the differences are settled when the carrying amount of the asset or liability is recovered or settled.

Because of temporary differences, the expense that an entity incurs in a reporting period usually comprises both current tax expense or income, and deferred tax expense or income.

Examples of Temporary Differences

Several examples of temporary differences are as follows:

Depreciation methods. A company may use straight-line depreciation for financial reporting but accelerated depreciation for tax purposes. This results in lower taxable income in early years and higher taxable income in later years, creating a temporary difference.
Allowance for doubtful accounts. For financial reporting, a company may estimate and record bad debt expense using an allowance for doubtful accounts. However, for tax purposes, bad debts are only deducted when they are actually written off, creating a timing difference.
Unearned revenue. Businesses may record unearned revenue as a liability until the service is performed (financial reporting), while tax rules may require recognizing it as taxable income when received. This creates a temporary difference as the revenue is taxed before being recognized in the financial statements.
Warranty liabilities. Companies estimate and recognize warranty expenses in financial statements when a product is sold. However, tax deductions for warranty costs are typically only allowed when the expenses are actually incurred, leading to a temporary difference.
Pension expenses. Companies may recognize pension expenses based on actuarial estimates in financial statements, while tax deductions are only permitted when actual contributions are made. This creates a timing difference between book and tax expenses.
Goodwill amortization. Under GAAP or IFRS, goodwill is not amortized but tested for impairment, while for tax purposes, goodwill is often amortized over a set period (e.g., 15 years under U.S. tax laws). This creates a temporary difference in expense recognition.
Capitalized interest. Some companies capitalize interest costs as part of an asset’s book value for financial reporting, but these costs may be deductible as incurred for tax purposes. This leads to different carrying amounts for the asset in financial and tax records.
Stock-based compensation. A company may recognize stock-based compensation expense in its financial statements over the vesting period. However, tax deductions are only allowed when the stock options are exercised, creating a temporary difference.
Investment in subsidiaries. If a company does not recognize deferred tax liability for undistributed earnings of a foreign subsidiary, but tax is due when profits are repatriated, this results in a temporary difference. The liability is recognized only when the company decides to distribute those earnings.
Litigation expenses. A business may accrue legal expenses for financial reporting when a lawsuit is probable and estimable. However, tax authorities may only allow deductions when the legal costs are actually paid, creating a temporary difference in expense recognition.