Valuation allowance for deferred tax assets

Definition

A valuation allowance for deferred tax assets is a reserve established to reduce the carrying amount of deferred tax assets on the balance sheet when it is more likely than not that some or all of the deferred tax assets will not be realized. This allowance reflects management's judgment about the realizability of deferred tax assets based on expected future taxable income and other relevant factors, ensuring that financial statements present an accurate financial position.

5 Must Know Facts For Your Next Test

1. The valuation allowance is recorded as a contra account that directly reduces the total amount of deferred tax assets reported on the balance sheet.
2. Management must assess both historical and projected future earnings when determining if a valuation allowance is necessary for deferred tax assets.
3. If it becomes probable that the deferred tax assets will be realized, the valuation allowance can be reversed, impacting income in that period.
4. The assessment for a valuation allowance must consider all available evidence, including positive and negative factors affecting future profitability.
5. Companies are required to disclose the nature and reasons for establishing or reversing any valuation allowance in their financial statements.

Review Questions

• How does management determine the need for a valuation allowance on deferred tax assets?
  • Management determines the need for a valuation allowance on deferred tax assets by evaluating both historical performance and forecasts of future taxable income. If it is more likely than not that some of the deferred tax assets will not be realized due to insufficient taxable income, a valuation allowance is established. This evaluation includes considering all relevant evidence, such as past earnings trends and current market conditions.
• Discuss the impact of reversing a valuation allowance on a company's financial statements.
  • Reversing a valuation allowance can significantly impact a company's financial statements, particularly net income and the balance sheet. When the valuation allowance is reversed because management believes it is now probable that deferred tax assets will be realized, it results in an increase in net income for that reporting period. Additionally, this reversal reduces the contra account against deferred tax assets on the balance sheet, improving the asset position.
• Evaluate how changes in market conditions might influence the assessment of a valuation allowance for deferred tax assets.
  • Changes in market conditions can greatly influence the assessment of a valuation allowance for deferred tax assets by altering expectations regarding future profitability. For instance, if market demand declines significantly, leading to lower revenue projections, management may conclude that realizing certain deferred tax assets is less likely. Conversely, improvements in market conditions or positive economic indicators could prompt management to reconsider previously established allowances, potentially leading to reversals and affecting reported earnings and overall financial health.

Related terms

Deferred tax asset: A deferred tax asset arises when a company pays more taxes to the government than it has incurred, creating a future tax benefit.

Future taxable income: Future taxable income is the income that is expected to be realized in future periods, which is crucial for assessing the realization of deferred tax assets.

Tax loss carryforward: A tax loss carryforward allows a company to use a current year's net operating losses to offset taxable income in future years, potentially leading to deferred tax assets.