3.1 Background

When a transaction affects the computation of income or loss for income tax reporting purposes but not for financial reporting purposes, or vice versa, and does not result in a difference between the income tax and financial reporting basis in an asset or liability, a permanent difference between financial reporting and taxable income arises. The income tax effects of permanent items are generally reflected in income tax expense corresponding with the amount of taxes payable or refundable for the current year and the entity’s annual effective tax rate (AETR). Deferred taxes are not recorded for permanent differences.

However, an entity does record deferred taxes for temporary differences. Typically, temporary differences do not affect total income tax expense or the entity’s AETR in the absence of a phased-in change in tax rate or other similar situations discussed later in this chapter. Rather, temporary differences generate additional taxable income or loss when the related amount for financial reporting purposes is recovered (asset) or settled (liability). For this reason, deferred taxes are always recorded on taxable and deductible temporary differences unless one of the exceptions in ASC 740-10-25-3 applies.

See Sections 1.3.2.1 and 1.3.3.1 for additional information about permanent and temporary differences, respectively, and their effects on income tax expense and the AETR.