Differences Between Tax and Accounting Figures: How Should Temporary and Permanent Differences Be Handled?

During the preparation and presentation of financial statements, many businesses encounter situations where accounting profit does not match taxable income. This is not an uncommon error but rather an inevitable consequence of the differences between accounting standards and tax regulations.

However, the critical issue is not whether differences exist, but whether businesses correctly identify, classify, and handle the nature of these differences. In particular, understanding temporary differences and permanent differences helps businesses manage tax risks while ensuring the transparency and reliability of their financial statements.

The Nature of Differences Between Accounting and Tax

In principle, accounting and taxation are built upon two different foundations.

Accounting aims to provide a true and fair view of an entity’s financial position and performance, whereas taxation focuses primarily on state revenue collection and tax administration.

As a result, the same economic transaction may be recognized differently under accounting standards and tax regulations.

These differences lead to situations where:

• Certain expenses are recognized in accounting records but are not deductible for tax purposes.

• Certain revenues or expenses are recognized at different points in time.

Consequently, two fundamental categories of differences arise: temporary differences and permanent differences.

Temporary Differences: Differences That Reverse Over Time

Temporary differences arise when there is a difference between the carrying amount of an asset or liability in the financial statements and its tax base, but that difference will reverse in future periods.

A typical example is depreciation of fixed assets.

While accounting may determine the depreciation period based on the asset’s actual useful life, tax authorities often prescribe specific depreciation ranges and limits. As a result, depreciation expenses recognized under accounting and taxation may differ from period to period, although these differences will eventually reverse over the asset’s useful life.

In substance, temporary differences do not eliminate tax obligations; they merely shift them between reporting periods.

Therefore, businesses need to recognize:

• Deferred income tax assets;

• Deferred income tax liabilities.

However, one particularly important consideration is that the recognition of deferred tax assets must be supported by the likelihood of future recovery. If a business cannot demonstrate sufficient future taxable profits, these assets may be disallowed during an audit.

Permanent Differences: Differences That Never Reverse

Unlike temporary differences, permanent differences are discrepancies that will never be adjusted or reversed in future periods.

These usually involve expenses recognized in accounting records but not deductible under tax regulations, such as:

• Expenses without valid supporting invoices or documentation;

• Expenses exceeding allowable limits under tax regulations;

• Administrative fines and penalties.

Such expenses are excluded from deductible expenses when determining taxable income, thereby increasing the company’s tax liability.

A key point is that permanent differences do not give rise to deferred taxes. Instead, they are handled directly through adjustments to taxable income for the current period.

In practice, this category often represents the highest tax risk because it is frequently the focus of tax inspections and assessments.

Distinguishing the Two Correctly to Avoid Material Misstatements

Confusing these two types of differences is one of the most common reasons financial statements require adjustment after an audit.

Fundamentally:

• Temporary differences are primarily technical issues related to timing differences in recognition.

• Permanent differences reflect the level of compliance with tax regulations.

If handled incorrectly:

• Businesses may recognize deferred taxes incorrectly;

• Or fail to exclude non-deductible expenses when finalizing tax obligations.

Both situations can result in significant financial and legal risks.

The Right Practical Approach for Businesses

From an auditing and advisory perspective, differences between accounting and tax figures should not be addressed reactively at year-end. Instead, they should be monitored and controlled throughout the entire accounting period.

A standard approach generally includes the following steps:

• First, businesses should prepare a reconciliation between accounting profit and taxable income in order to identify all differences arising during the period.

• Next, each item should be clearly classified as either a temporary difference or a permanent difference based on whether it is expected to reverse in the future.

For temporary differences, businesses should assess deferred tax obligations and evaluate recognition criteria, particularly with respect to deferred tax assets.

At the same time, expenses should be reviewed for reasonableness, validity, and compliance to minimize tax risks arising from permanent differences.

• Finally, all differences should be properly documented and supported with clear explanations, ensuring readiness for external audits and tax inspections.

Expert Perspective: Common Mistakes Businesses Often Make

In practice, many businesses do not face problems because differences arise, but because they fail to manage and control those differences effectively.

One common mistake is the failure to prepare tax-accounting reconciliation schedules, resulting in an inability to monitor differences between the two reporting systems.

Additionally, misunderstanding the nature of differences may cause businesses to incorrectly recognize deferred taxes or improperly handle tax finalization procedures.

Another frequent issue is the tendency to adopt a “firefighting” approach—reviewing discrepancies only when an audit or tax inspection occurs, rather than proactively monitoring them throughout the year.

Conclusion

Differences between accounting figures and tax figures are an inevitable part of business operations.

However, correctly understanding and properly handling temporary differences and permanent differences is essential to maintaining both financial security and legal compliance.

A well-controlled accounting system is not one that has no differences at all. Rather, it is a system capable of identifying differences, understanding their underlying nature, and addressing them proactively and appropriately.

Viet Australia
Viet Australia Auditing Company is an independent auditing organization licensed and established in 2007 in the Socialist Republic of Vietnam.