Updated for the 2026-2027 CFA® Level I curriculum.
Companies often report one profit number to shareholders and a different number to tax authorities. The gap comes from two sources: differences that will reverse over time and differences that never reverse. Telling these apart depends on comparing each asset and liability's carrying amount to its tax basis. This distinction drives deferred tax accounting, which the exam tests directly.
Quick Answer
A temporary difference arises when an asset or liability's carrying amount differs from its tax base, and that gap reverses in a future period. A permanent difference arises when accounting profit and taxable income differ for a reason that never reverses, such as tax-exempt income or non-deductible fines. Only temporary differences create deferred tax assets or liabilities. The tax basis balance sheet compares each item's book value to its income tax basis to find these gaps.
Key Takeaways
A temporary difference reverses in a future period and creates a deferred tax asset or liability.
A permanent difference never reverses and has no deferred tax consequence.
The tax base of an asset is the amount deductible for tax purposes in future periods as the asset's benefits are used.
The tax base of a liability equals its carrying amount minus any amount deductible for tax purposes in the future.
Comparing carrying amount to tax base, item by item, is how analysts build a tax basis balance sheet view of the company.
Permanent differences change the effective tax rate but do not signal a future cash tax reversal.
What You Need to Know for CFA Level I
The LOS asks you to contrast temporary and permanent differences, not just define them. Expect questions that require you to classify a scenario correctly.
The core skill is identifying whether a book-tax gap will reverse (temporary) or never reverse (permanent).
You must be able to calculate the tax base of a simple asset or liability given deductible amounts.
Know the boundary with the next note: this page explains why a temporary difference exists; the next note explains how it becomes a deferred tax asset or liability on the balance sheet.
The most common trap is treating every book-tax difference as temporary. Permanent differences look similar on the income statement but never create a deferred tax account.
Permanent Differences: No Future Reversal
A permanent difference occurs when an item affects accounting profit but never affects taxable income, or the reverse. Because the gap never closes, it has no deferred tax effect at all.
Common sources of permanent differences include:
Interest income from municipal bonds, which is often tax-exempt but still included in accounting profit.
Fines, penalties, or certain non-deductible entertainment expenses, which reduce accounting profit but are disallowed for tax purposes.
Life insurance proceeds on a company-owned policy, which may be tax-free but still recorded as income.
Permanent differences change the company's effective tax rate compared to the statutory rate. They do not change taxes payable in later years because there is nothing left to reverse.
Temporary Differences: Timing Creates Deferred Tax
A temporary difference occurs when the carrying amount of an asset or liability on the financial statements differs from its tax base, and the gap will close as the item is used, sold, or settled. These differences shift when tax is paid, not whether it is paid.
Two directions matter:
Taxable temporary difference
Leads to a deferred tax liability. Taxes payable in the future will be higher than current tax expense suggests.
Deductible temporary difference
Leads to a deferred tax asset. Taxes payable in the future will be lower than current tax expense suggests.
This page focuses on identifying the difference and its direction. The recognition and measurement of the resulting deferred tax asset or liability is covered in the next study note.
Finding the Tax Base of Assets and Liabilities
The tax base is the value tax authorities assign to an asset or liability. Comparing it to the carrying amount on the financial statements is how you spot a temporary difference. This comparison is sometimes called building a tax basis balance sheet, since you repeat it across every major asset and liability.
Tax Base of an Asset
Tax Baseasset = Future tax-deductible amount,
where:
Tax Baseasset: amount the company can deduct for tax purposes as it recovers the asset's economic benefits,
Future tax-deductible amount: remaining cost not yet used for tax deductions.
If the carrying amount of an asset exceeds its tax base, the company will pay more tax later than current expense implies. This is a taxable temporary difference.
Tax Base of a Liability
Tax Baseliability = Carrying Amount – Future tax-deductible amount,
where:
Tax Baseliability: carrying amount adjusted for any portion still deductible in the future,
Carrying Amount: reported balance sheet value of the liability, and
Future tax-deductible amount: amount that will be deductible for tax purposes when the liability is settled.
If the carrying amount of a liability exceeds its tax base, this is a deductible temporary difference. For revenue received in advance, use the special rule: carrying amount minus the revenue that will not be taxable in future periods. An advance already taxed commonly has a tax base of zero and creates a deductible temporary difference.
Temporary vs Permanent: Side-by-Side Comparison
Feature | Temporary Difference | Permanent Difference |
|---|---|---|
Definition | Gap between carrying amount and tax base | Gap between accounting profit and taxable income |
Reverses in future? | Yes | No |
Creates deferred tax? | Yes, DTA or DTL | No |
Typical example | Accelerated tax depreciation vs. straight-line book depreciation | Tax-exempt municipal bond interest |
Effect on effective tax rate | Usually no ETR effect with a constant tax rate and full deferred tax recognition; tax-rate or recognition changes can affect ETR | Permanent shift from statutory rate |
Working Example
Harborline Shipping Co. buys equipment for $600,000. For financial reporting, it uses straight-line depreciation over 10 years, recording $60,000 of depreciation in year 1. For tax purposes, it uses accelerated depreciation and deducts $100,000 in year 1. Separately, Harborline earns $20,000 of interest income from municipal bonds during the year. This interest is included in accounting profit but is tax-exempt under local law.
Step 1: Find the equipment's carrying amount and tax base after year 1.
Carrying amount = $600,000 – $60,000 = $540,000.
Tax base = $600,000 – $100,000 = $500,000.
Step 2: Compare the two values.
Carrying amount ($540,000) is greater than tax base ($500,000). This is a taxable temporary difference of $40,000.
Step 3: Classify the municipal bond interest.
The $20,000 is included in accounting profit but will never appear in taxable income. It does not reverse. This is a permanent difference.
The equipment creates a temporary difference that will reverse as book depreciation catches up to tax depreciation in later years, setting up a deferred tax liability (covered in the next note). The municipal bond interest lowers Harborline's effective tax rate permanently and has no deferred tax consequence.
Apply the Liability Rule to a Warranty Provision
Assume a company reports a $60,000 warranty liability. Local tax law allows a deduction only when claims are paid, and all $60,000 is expected to qualify for deduction on settlement.
Warranty liability tax base = $60,000 – $60,000 = $0.
Assume a company reports a $60,000 warranty liability. Local tax law allows a deduction only when claims are paid, and all $60,000 is expected to qualify for deduction on settlement.
Warranty liability tax base = $60,000 – $60,000 = $0.
The carrying amount exceeds the tax base by $60,000, creating a deductible temporary difference. Settlement produces a future tax deduction without a matching new accounting expense, because the expense was already recognized.
If a $10,000 fine is never tax deductible, its liability tax base is instead $10,000: carrying amount less zero future deduction. The fine creates a permanent profit difference, but this liability has no temporary difference.
Apply the Special Rule to Revenue Received in Advance
Suppose a $24,000 customer advance is already taxable when cash is collected, but remains a contract liability until services are delivered. None of the future accounting revenue will be taxed again.
Advance-revenue liability tax base = $24,000 – $24,000 = $0.
The resulting $24,000 deductible temporary difference reflects future accounting revenue without future taxable revenue. If tax law instead recognizes revenue when the services are performed, the liability tax base is $24,000 and no such temporary difference arises.
Always read the stated tax treatment. Cash collection or the word liability alone does not determine the tax base.
Common Exam Traps
Treating every book-tax gap as temporary
Some candidates assume all differences between accounting profit and taxable income will eventually reverse. Permanent differences, like tax-exempt income, never reverse and never create a deferred tax balance.
Misapplying the liability tax base formula
A common error is using the asset formula (future deductible amount alone) for a liability. The liability formula requires subtracting the future deductible amount from the carrying amount, not reporting it alone.
Assuming an effective tax rate change always signals a temporary difference
Permanent differences change ETR. Temporary differences alone generally do not when tax rates are constant and related deferred taxes are fully recognized; changes in rates or recognition can create an ETR effect. Only temporary differences imply a future reversal in cash taxes.
Confusing this note with deferred tax recognition
Identifying a temporary difference is step one. Deciding whether to recognize a deferred tax asset or liability, and at what amount, belongs to the next study note.
Practice Question
ABC Co. reports a warranty liability of $40,000 on its balance sheet for estimated future warranty claims. Under tax law, warranty costs are deductible only when actually paid. ABC has not paid any warranty claims yet. What is the tax base of this liability, and how should the difference be classified?
Tax base = $40,000; permanent difference.
Tax base = $0; temporary difference.
Tax base = $0; permanent difference.
Correct Answer: B
Tax base of a liability equals carrying amount minus the amount deductible in the future. The full $40,000 will be deductible when paid, so:
Tax base = $40,000 – $40,000 = $0.
Carrying amount ($40,000) does not equal tax base ($0), so this is a temporary difference. It will reverse once ABC pays the warranty claims and takes the tax deduction, creating a deductible temporary difference.
Option A: Incorrectly assumes no portion of the liability will ever be tax-deductible, and mislabels a reversible gap as permanent.
Option C: Calculates the tax base correctly but mislabels the gap as permanent. Since the deduction will occur once claims are paid, the difference reverses and is temporary.
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FAQs About Temporary vs Permanent Differences and Tax Bases
What is the tax base of an asset?
For an asset whose recovery is taxable, its tax base is the amount deductible against that recovery. If recovery is not taxable, the tax base equals the carrying amount. It is often lower than carrying amount when tax depreciation runs faster than book depreciation.
What is the tax base of a liability?
It equals the liability's carrying amount minus any amount that will be deductible for tax purposes when the liability is settled. For revenue received in advance, the tax base can be lower than the carrying amount.
How is a tax basis balance sheet different from the financial reporting balance sheet?
A tax basis balance sheet values each asset and liability using tax rules instead of accounting standards. Comparing the two, item by item, is how you identify temporary differences and their direction.
Do permanent differences ever create a deferred tax asset or liability?
No. Permanent differences never reverse, so there is nothing to defer. They only affect the current period's effective tax rate.
Why does the CFA exam test temporary versus permanent differences separately from deferred tax assets and liabilities?
Classifying the difference correctly is a prerequisite skill. The exam tests this classification on its own before testing how a temporary difference becomes a deferred tax asset or liability.