Key Takeaways
- A temporary difference reverses when the asset is recovered or the liability is settled; a permanent difference persists indefinitely.
- Only temporary differences produce deferred tax balances on the balance sheet.
- Misclassifying even one item can shift the effective tax rate reconciliation by several percentage points on mid-market engagements.
- Apply temporary difference treatment when the tax deduction or income is a matter of timing; apply permanent difference treatment when tax law denies or exempts the item outright.
What is IAS 12 Temporary Difference vs Permanent Difference?
| Dimension | Temporary difference | Permanent difference |
|---|---|---|
| Defined in IAS 12? | Yes. IAS 12.5 defines it as the difference between carrying amount and tax base | No. IAS 12 addresses these indirectly through the tax base mechanism; the term is practitioner shorthand |
| Reversal | Reverses when the underlying asset is recovered or the liability is settled | Never reverses; the gap between accounting profit and taxable profit persists |
| Deferred tax effect | Creates a deferred tax liability (taxable) or deferred tax asset (deductible) | None. Affects current tax only |
| Where it surfaces | Deferred tax note, balance sheet, effective tax rate reconciliation | Current tax computation, effective tax rate reconciliation (IAS 12.81(c)) |
| Common examples | Accelerated tax depreciation, fair value adjustments on acquisition, provisions deductible only on cash payment | Non-deductible fines, tax-exempt participation dividends, entertainment expenses disallowed by statute, non-deductible goodwill amortisation |
Decision rule: Classify a book-to-tax difference as temporary when the tax deduction or income will arise in a future period. Classify it as permanent when tax law denies or exempts the item outright, with no future reversal possible.
When the distinction matters on an engagement
The classification drives whether a deferred tax balance exists. Get it wrong in one direction and the balance sheet carries a deferred tax liability or asset that should not be there. Get it wrong in the other direction and a required deferred tax balance is missing entirely. IAS 12.81(c) forces the entity to reconcile the statutory tax rate to the effective rate, and permanent differences are the primary reconciling items. If the engagement team classifies a permanent difference as temporary, the deferred tax working paper and the rate reconciliation will both fail to tie.
On a first-year engagement, auditors cannot rely on the prior-year classification. The team tests each material book-to-tax difference against the local tax code to confirm whether a future deduction or inclusion exists (IAS 12.7–8 for the tax base of assets, IAS 12.8 for liabilities). Accepting management's blanket split without verifying the underlying tax provisions leaves the deferred tax balance exposed to misstatement in both directions.
Worked example: Rossi Alimentari S.p.A.
Client: Italian food production company, FY2025, revenue EUR 67M, IFRS reporter. Italy's corporate income tax rate (IRES) is 24%, with IRAP at approximately 3.9%. For this example, the combined rate used is 27.9%.
Step 1 — Identify the temporary difference (accelerated tax depreciation)
Rossi purchased packaging machinery in January 2025 for EUR 1,200,000. IFRS depreciation is straight-line over eight years (EUR 150,000 per year). Italian tax law permits a super-depreciation deduction of 40% in year one (EUR 480,000 tax depreciation). At 31 December 2025, the carrying amount is EUR 1,050,000 and the tax base is EUR 720,000. The taxable temporary difference is EUR 330,000.
Step 2 — Recognise deferred tax
EUR 330,000 at 27.9% produces a deferred tax liability of EUR 92,070. This difference will reverse over the remaining seven years as IFRS depreciation continues while the tax base has already absorbed the accelerated deduction.
Step 3 — Identify the permanent difference (non-deductible entertainment)
Rossi incurred EUR 95,000 in client entertainment costs during FY2025. Under Italian tax law, 75% of entertainment expenses (EUR 71,250) is deductible, leaving EUR 23,750 permanently non-deductible. No future period will grant a deduction for this EUR 23,750.
Step 4 — Effect on the tax computation
The non-deductible EUR 23,750 increases taxable profit by the same amount relative to accounting profit. The current tax cost rises by EUR 6,626 (EUR 23,750 at 27.9%). This amount appears as a reconciling item in the effective tax rate reconciliation under IAS 12.81(c). No balance sheet effect arises.
Conclusion: If the team had treated the non-deductible entertainment as a temporary difference, EUR 6,626 would have been posted to the deferred tax liability instead of current tax expense. The balance sheet would carry a liability that will never settle, and the rate reconciliation would understate permanent items by that amount.
Why it matters in practice
Teams sometimes recognise a deferred tax asset for permanently non-deductible expenses (entertainment, fines) on the assumption that the deduction might become available in a future period. IAS 12.24 permits a deferred tax asset only when probable future taxable profit exists to absorb a deductible temporary difference. If the item is permanently non-deductible under the tax code, no future deduction will arise, and recognising a deferred tax asset misstates both the balance sheet and the tax charge.
The effective tax rate reconciliation under IAS 12.81(c) often groups all permanent differences into a single "other" line. The FRC has flagged insufficient disaggregation of the tax rate reconciliation as a recurring finding in its thematic reviews of corporate tax disclosures. Each material permanent difference should appear as a separate reconciling item.
Related terms
Frequently asked questions
How do I tell whether a book-to-tax difference is temporary or permanent?
Check the local tax code for the item in question. If the difference arises because tax law permits or requires a different timing of recognition (accelerated depreciation, provisions deductible on payment), the item will reverse and is temporary. If tax law denies the deduction or exempts the income outright with no carry-forward, no future reversal will occur and the item is permanent. IAS 12.7–8 define the tax base test that drives this classification.
Does IAS 12 actually use the term “permanent difference”?
No. IAS 12 builds its framework entirely around temporary differences (the gap between carrying amount and tax base). Permanent differences are not defined in the standard. The concept exists in practice because certain items produce no temporary difference at all: the carrying amount and the tax base are identical (since the item was never deductible), so IAS 12.15 generates no deferred tax. Practitioners use “permanent difference” as shorthand for this outcome.
Can a difference change from temporary to permanent or vice versa?
Yes. A change in tax law can convert a previously deductible item into a permanently non-deductible one (or the reverse). When this happens, the entity derecognises the existing deferred tax balance in the period the law changes. IAS 12.60 requires deferred tax to reflect the tax consequences that follow from the manner in which the entity expects to recover or settle the carrying amount. If the manner changes because the tax law changes, the classification follows.