What is a Deductible Temporary Difference?

Deductible Temporary Difference

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Deductible Temporary Difference

A deductible temporary difference arises in accounting for income taxes. It’s the difference between the carrying amount of an asset or liability for financial reporting purposes and its tax base that will result in deductible amounts in future periods when the carrying amount of the asset or liability is recovered or settled.

In simpler terms, it’s a difference that will lower your taxable income in the future, hence, reducing your future tax payments. This difference usually occurs because the recognition of income or expenses for tax purposes is delayed compared to when it is recognized for financial reporting purposes.

For instance, warranty expenses are often recognized earlier for financial reporting purposes than for tax purposes. When a company sells a product with a warranty, it usually recognizes an expense for future warranty costs in its financial statements. However, for tax purposes, the expense is typically recognized when the company actually incurs the warranty costs. This difference creates a deductible temporary difference. In the future, when the warranty costs are incurred, the company will be able to deduct them on its tax return, reducing its taxable income.

Deductible temporary differences often give rise to deferred tax assets on the balance sheet, as they are expected to decrease future tax payments. It’s important for a company to assess the likelihood of utilizing these deferred tax assets because if it’s not probable that the company will have sufficient taxable income in the future, a valuation allowance may be needed to reduce the deferred tax assets to the amount that is more likely than not to be realized.

Example of a Deductible Temporary Difference

Suppose a company sells products with a warranty and the company estimates that it will have to pay $10,000 in warranty expenses over the next year. For financial reporting purposes, the company recognizes this $10,000 expense in the current year when the products are sold.

However, for tax purposes, the company cannot deduct these warranty expenses until it actually incurs them. So, let’s say in the current year, the company only incurs $4,000 in warranty costs. This means that the company can only deduct $4,000 on its tax return for the current year.

This creates a deductible temporary difference of $6,000 ($10,000 – $4,000), which is the amount of warranty expenses that the company has recognized but has not yet been able to deduct for tax purposes.

This deductible temporary difference of $6,000 will give rise to a deferred tax asset. Assuming a tax rate of 25%, the company would report a deferred tax asset of $1,500 ($6,000 x 25%) on its balance sheet. This represents the future tax savings that the company expects to realize when it deducts the remaining warranty expenses on its tax return in the future.

Remember that this deferred tax asset is only valuable if the company expects to have enough taxable income in the future to utilize the tax deductions. If it’s not probable that the company will have sufficient taxable income, the company may need to reduce the deferred tax asset by a valuation allowance.

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