A valuation allowance is an important concept in accounting that pertains to deferred tax assets. It involves determining the likelihood of realizing these assets, and if necessary, reducing their value on the balance sheet. In this section, we will explore the definition of a valuation allowance, its accounting treatment, and its impact on income tax expense.
Key Takeaways:
- A valuation allowance offsets a deferred tax asset that is unlikely to be realized in full or in part.
- The accounting treatment involves establishing a contra-asset account to negate the balance of the deferred tax asset.
- The offsetting credit is usually applied to the income tax expense, reducing net income.
- Professional judgment is required to assess the need for a valuation allowance and evaluate all positive and negative evidence.
- Companies must consider various factors, such as future taxable income, temporary differences, and tax planning strategies when determining the need for a valuation allowance.
Valuation Allowance for Deferred Tax Assets – The Basics
A valuation allowance for deferred tax assets is a mechanism that companies use when it is likely (at a probability level of more than 50%) that they will not be able to realize some or all of their deferred tax assets. This assessment is conducted by companies to determine whether an allowance is required, regardless of whether they are in a net deferred tax liability position or not. The purpose of establishing a valuation allowance is to ensure that financial statements do not overstate the value of assets and provide a more realistic view of the amount of deferred tax assets that may be realized in the future.
The realization of deferred tax assets refers to the benefit obtained from a reduction in future taxes payable or an increase in future taxes refundable. By establishing a valuation allowance, companies can accurately reflect the potential realization of deferred tax assets, thus preventing an overstatement of assets and presenting a more accurate financial position.
It is important to note that the need for a valuation allowance is determined based on a probability assessment and careful evaluation of future income projections and all available evidence. A valuation allowance ensures that financial statements provide a true representation of the company’s financial condition by reflecting the estimated amount of deferred tax assets that will likely be realized.
Valuation Allowance for Deferred Tax Assets – Summary:
- A valuation allowance is established when it is more likely than not that a company will not be able to realize some or all of its deferred tax assets.
- This assessment is conducted regardless of the company’s net deferred tax liability position.
- The establishment of a valuation allowance ensures that financial statements accurately reflect the potential realization of deferred tax assets and prevent an overstatement of assets.
- The need for a valuation allowance is determined based on probability assessments, careful evaluation of future income projections, and available evidence.
Reasons for Using a Valuation Allowance
A valuation allowance may be necessary for a company if it determines that it is more likely than not that it will not have sufficient taxable income in the future to utilize its deferred tax assets. This accounting treatment involves establishing a valuation allowance as a contra-asset account to offset the deferred tax asset. The phrase “more likely than not” generally means a probability level of more than 50%. Companies must carefully evaluate their future income projections and consider all positive and negative evidence to determine the need for a valuation allowance. If sources of taxable income are sufficient to support the realization of deferred tax assets, a valuation allowance may not be necessary. The reporting of a valuation allowance ensures that financial statements accurately reflect the company’s financial condition.
There are several reasons why a company may need to use a valuation allowance:
- The company may have experienced significant losses in previous years, resulting in deferred tax assets that are unlikely to be realized in the future.
- The company may have significant temporary differences between book and tax income, which may not result in taxable income in the future.
- The company may have tax planning strategies in place that reduce its taxable income in the future.
- The company may operate in an industry that is experiencing significant changes or uncertainties, making it difficult to predict future taxable income.
It is important for companies to carefully assess their future income projections and consider all available evidence when determining the need for a valuation allowance. This ensures that financial statements accurately reflect the company’s financial condition and provide investors with a realistic view of the amount of deferred tax assets likely to be realized in the future.
Example:
For example, let’s consider a company that has a deferred tax asset of $100,000 on its balance sheet. After a thorough evaluation of future income projections, the company determines that only $70,000 of the deferred tax asset is likely to be realized in future periods. In this case, the company would establish a valuation allowance of $30,000 to accurately reflect the expected realization of the deferred tax asset. This would be recorded as a debit to the income tax expense and a credit to the valuation allowance.
Table: Reasons for Using a Valuation Allowance
| Reasons | Description |
|---|---|
| Significant losses | Deferred tax assets are unlikely to be realized in the future due to previous significant losses. |
| Temporary differences | There are significant differences between book and tax income, which may not result in taxable income in the future. |
| Tax planning strategies | Tax planning strategies are in place to reduce taxable income in the future. |
| Industry changes | The company operates in an industry that is experiencing significant changes or uncertainties, making it difficult to predict future taxable income. |
The existence of a valuation allowance ensures that financial statements accurately reflect the company’s financial condition and provides transparency to investors and stakeholders.
Example of Valuation Allowance Calculation
Let’s take a closer look at an example to understand how a valuation allowance is calculated. Consider XYZ Corp, which has a deferred tax asset of $100,000 on its balance sheet, resulting from net operating losses (NOLs) incurred in previous years.
After careful evaluation of future income projections, XYZ Corp determines that only $70,000 of the deferred tax asset is likely to be realized in future periods. In order to accurately reflect this expected realization, a valuation allowance of $30,000 needs to be created.
This valuation allowance is recorded as a debit to the income tax expense and a credit to the valuation allowance account. By creating this allowance, XYZ Corp ensures that its financial statements provide a more realistic view of the amount of deferred tax assets that will actually be realized.
FAQ
What is a valuation allowance?
A valuation allowance is an account that offsets a deferred tax asset when it is more likely than not that some portion or all of the deferred tax asset will not be realized. It reduces the value of deferred tax assets to an amount expected to be realized in future tax returns.
How is a valuation allowance accounted for?
The accounting treatment involves establishing a contra-asset account that negates the balance of the deferred tax asset. The offsetting credit is usually to the income tax expense, which increases it and reduces net income.
What factors are considered when determining the need for a valuation allowance?
Companies must assess the likelihood of future taxable income and consider sources such as the reversal of existing taxable temporary differences, future taxable income exclusive of temporary differences, taxable income in prior carryback years, and tax planning strategies. The valuation allowance is re-evaluated each reporting period based on the latest available information.
When is a valuation allowance necessary?
A valuation allowance for deferred tax assets is necessary when it is more likely than not (a probability level of more than 50%) that some or all of the deferred tax assets will not be realized. Companies undergo a valuation allowance assessment to determine the need for an allowance.
Why is a valuation allowance important?
The establishment of a valuation allowance ensures that financial statements do not overstate assets and provides a more realistic view of the amount of deferred tax assets likely to be realized in the future.
Can a company be exempt from a valuation allowance assessment if it is in a net deferred tax liability position?
No, being in a net deferred tax liability position does not exempt a company from the valuation allowance assessment. The need for a valuation allowance requires significant professional judgment and involves evaluating all positive and negative evidence.
How is a valuation allowance calculated?
The calculation of a valuation allowance involves evaluating future income projections. If sources of taxable income are sufficient to support the realization of deferred tax assets, a valuation allowance may not be necessary.
Can you provide an example of a valuation allowance calculation?
Sure! Let’s consider the example of XYZ Corp. The company has a deferred tax asset of $100,000 on its balance sheet from net operating losses (NOLs) in previous years. After evaluating future income projections, XYZ Corp estimates that only $70,000 of the deferred tax asset will be realized in future periods. Therefore, a valuation allowance of $30,000 needs to be created to accurately reflect the expected realization of the deferred tax asset.
