Temporary vs. permanent differences
Temporary differences reverse over time and create deferred tax assets or liabilities (e.g., depreciation timing, warranty accruals). Permanent differences never reverse and never create deferred taxes (e.g., municipal bond interest, meals & entertainment disallowed for tax, life insurance premiums on key employees).
Which way does it go?
| Situation | Result |
|---|---|
| Book income > tax income now, reverses later (e.g., accelerated tax depreciation) | Deferred tax liability |
| Book expense recognized before tax-deductible (e.g., warranty accrual, bad debt allowance) | Deferred tax asset |
| Revenue received in advance, taxable now, recognized later for book | Deferred tax asset |
EXAM TIP: A simple way to remember it: if a book expense is deducted for tax later than for books (or book revenue is taxed earlier than for books), you get a deferred tax asset — you're owed a future tax benefit.
Valuation allowance
A deferred tax asset is recognized in full, then reduced by a valuation allowance if it's more likely than not (greater than 50% probability) that some or all of the DTA will not be realized. Positive evidence (a strong earnings history, existing contracts) can offset negative evidence (recent losses, expiring carryforwards) in this judgment.
EXAMPLE: A company has a $400,000 deferred tax asset from a net operating loss carryforward. Given a history of losses and no evidence of future taxable income, management determines it's more likely than not that only $150,000 will be realized. A valuation allowance of $250,000 is recorded, reducing the net DTA to $150,000.
Rate changes
Deferred tax assets and liabilities are measured using enacted tax rates expected to apply when the temporary difference reverses. When a tax law changes the rate, the effect is recognized immediately, in the period of enactment — not the effective date.