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📈Financial Accounting II

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7.2 Valuation Allowances and Tax Rate Changes

5 min readLast Updated on July 30, 2024

Valuation allowances and tax rate changes play a crucial role in accounting for deferred taxes. These concepts impact how companies report their tax assets and liabilities, reflecting the likelihood of realizing future tax benefits and adapting to changing tax laws.

Understanding these elements is key to grasping the bigger picture of income tax accounting. They affect a company's financial statements, influencing reported income, asset values, and overall financial health. Let's dive into how these factors shape deferred tax reporting.

Valuation allowances for deferred tax assets

Deferred tax assets and their realization

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  • Deferred tax assets represent the future tax benefits a company expects to receive, often due to temporary differences between book and taxable income or carryforwards of tax losses and credits
  • Companies must assess the likelihood of realizing deferred tax assets based on available positive and negative evidence
    • Positive evidence supports the realization of deferred tax assets (strong earnings history, expected future profitability, existence of deferred tax liabilities that will reverse in the same period)
    • Negative evidence suggests that deferred tax assets may not be fully realizable (cumulative losses in recent years, expected future losses, lack of sufficient taxable income to utilize tax benefits before expiration)

Valuation allowance and its assessment

  • A valuation allowance is a contra-asset account that reduces the carrying value of deferred tax assets when it is more likely than not that some portion or all of the deferred tax assets will not be realized
  • If negative evidence outweighs positive evidence, a valuation allowance is necessary to reduce deferred tax assets to the amount more likely than not to be realized
  • Examples of situations requiring a valuation allowance:
    • A company has a history of operating losses and expects future losses, making it unlikely to generate sufficient taxable income to utilize its deferred tax assets
    • A company has deferred tax assets related to tax credit carryforwards that are set to expire in the near future, and the company does not expect to generate enough taxable income to utilize the credits before expiration

Tax rate changes on deferred taxes

Impact of tax rate changes on deferred taxes

  • Deferred tax assets and liabilities are measured using the enacted tax rates expected to apply to taxable income in the years in which those temporary differences are expected to be recovered or settled
  • When tax rates change, companies must remeasure their deferred tax assets and liabilities to reflect the new tax rates expected to be in effect when the temporary differences reverse
    • If tax rates increase, deferred tax assets will increase in value, and deferred tax liabilities will also increase, resulting in a net deferred tax expense
    • If tax rates decrease, deferred tax assets will decrease in value, and deferred tax liabilities will also decrease, resulting in a net deferred tax benefit

Recognition and consideration of tax rate changes

  • The effect of a change in tax rates on deferred tax assets and liabilities is recognized as a discrete item in the income tax expense or benefit in the period that includes the enactment date of the tax rate change
  • Companies must also consider the impact of tax rate changes on the realizability of deferred tax assets and adjust valuation allowances accordingly
  • For example, if a tax rate decrease makes it more likely than not that certain deferred tax assets will not be realized, the company must record a valuation allowance against those assets in the period of the tax rate change

Accounting for valuation allowances and tax rates

Changes in valuation allowances

  • Changes in valuation allowances are recognized in the period in which the change occurs and are included in income tax expense or benefit on the income statement
    • An increase in the valuation allowance results in additional income tax expense, while a decrease in the valuation allowance results in an income tax benefit
  • When a change in the valuation allowance is due to a change in tax rates, the effect of the tax rate change on the valuation allowance is also recognized as a discrete item in income tax expense or benefit

Changes in tax rates

  • Changes in tax rates that impact deferred tax assets and liabilities are recognized as a component of income tax expense or benefit in the period that includes the enactment date of the tax rate change
    • The effect of the tax rate change is calculated by remeasuring deferred tax assets and liabilities at the new enacted tax rate and recording the difference as a discrete item in income tax expense or benefit
  • Companies must disclose the significant components of income tax expense, including the effects of changes in valuation allowances and tax rates, in the notes to the financial statements

Financial statement impacts of deferred taxes

Income statement effects

  • On the income statement, changes in valuation allowances and tax rates are reflected in the income tax expense or benefit line item, affecting net income and earnings per share
    • An increase in the valuation allowance or a tax rate increase will result in higher income tax expense and lower net income, while a decrease in the valuation allowance or a tax rate decrease will result in lower income tax expense and higher net income
  • For example, if a company records a valuation allowance against its deferred tax assets due to expected future losses, it will report higher income tax expense and lower net income in the current period

Balance sheet effects

  • On the balance sheet, changes in valuation allowances and tax rates impact the carrying value of deferred tax assets and liabilities
    • An increase in the valuation allowance reduces the carrying value of deferred tax assets, while a decrease in the valuation allowance increases the carrying value of deferred tax assets
    • A tax rate increase will result in an increase in both deferred tax assets and liabilities, while a tax rate decrease will result in a decrease in both deferred tax assets and liabilities
  • Analysts and investors should carefully examine the effects of valuation allowances and tax rate changes on a company's financial statements to understand their impact on profitability, financial position, and future cash flows
    • Large changes in valuation allowances or tax rates may signal changes in a company's expected future profitability or indicate exposure to tax law changes that could affect future financial performance

Key Terms to Review (15)

Asc 740: ASC 740 is the Accounting Standards Codification topic that provides guidance on accounting for income taxes, particularly in how companies recognize, measure, and disclose their income tax obligations and benefits. This standard helps ensure that financial statements accurately reflect a company's tax position, which is crucial for understanding its financial health and future cash flows. ASC 740 includes principles regarding tax rates, the recognition of tax benefits, and adjustments for uncertain tax positions.
Balance Sheet: A balance sheet is a financial statement that provides a snapshot of a company's assets, liabilities, and equity at a specific point in time. It shows what the company owns and owes, offering insight into its financial health and stability.
Change in enacted tax rate: A change in enacted tax rate refers to the modification of the legal tax rate that is applied to taxable income, impacting both current and deferred tax liabilities. This change can arise from new legislation or amendments to existing tax laws, and it affects how companies account for their income taxes, particularly concerning valuation allowances and the measurement of deferred tax assets and liabilities.
Deferred Tax Assets: Deferred tax assets are amounts that can be used to reduce future tax liabilities, representing taxes that have been paid or carried forward but not yet recognized in the financial statements. They typically arise from temporary differences between accounting income and taxable income, such as expenses that are recognized in one period for accounting purposes but deducted in another for tax purposes. Understanding these assets is crucial for evaluating a company's future tax position and overall financial health.
Deferred Tax Liabilities: Deferred tax liabilities are amounts that a company owes in future taxes due to temporary differences between the accounting and tax treatment of certain transactions. These liabilities arise when income is recognized for accounting purposes before it is recognized for tax purposes, resulting in a future tax obligation that will need to be settled.
Expected Credit Loss Model: The expected credit loss model is a framework used to estimate the potential losses from defaults on financial assets, such as loans and receivables. This model emphasizes forward-looking information, requiring companies to recognize expected credit losses over the life of an asset, rather than waiting for a default to occur. It plays a significant role in determining valuation allowances and impacts how financial statements reflect the risk of credit losses.
Fair Value Measurement: Fair value measurement is the process of determining the estimated worth of an asset or liability based on current market conditions, rather than historical cost. This approach reflects how much an entity would receive or pay in an orderly transaction between market participants at the measurement date, ensuring that financial statements provide more relevant and timely information about an entity's financial position.
Gross versus Net Presentation: Gross versus net presentation refers to the method of displaying financial information, where gross presentation shows the total amounts of revenues and expenses without any deductions, while net presentation reflects amounts after deductions, such as allowances or tax effects. This distinction is crucial for understanding how valuation allowances and tax rate changes impact a company's financial statements, as it influences the reported performance and position of the business.
IFRS 12: IFRS 12 is an International Financial Reporting Standard that sets out disclosure requirements for interests in other entities. It aims to provide transparency regarding the nature, risks, and financial impacts of an entity’s investments in subsidiaries, joint arrangements, associates, and unconsolidated structured entities, which is critical for understanding valuation allowances and tax rate changes.
Impairment Loss: Impairment loss refers to a permanent reduction in the carrying value of an asset, indicating that its market value has fallen below its book value and it cannot recover its original cost. This concept is critical as it affects the financial statements by recognizing losses when an asset's future cash flows are not expected to cover its carrying amount, influencing decisions related to investments and financial reporting.
Income Statement: An income statement is a financial report that summarizes a company's revenues, expenses, and profits or losses over a specific period, typically a quarter or a year. It provides key insights into the company's operational performance, allowing stakeholders to assess profitability and efficiency in generating income.
Reassessment of Tax Positions: Reassessment of tax positions refers to the evaluation and adjustment of a company's tax strategies and positions taken in previous tax filings. This process occurs when there are changes in relevant laws, regulations, or the company’s own financial circumstances that could affect the validity or outcome of those positions. Regular reassessments ensure compliance with tax laws and can impact the company's financial statements, particularly in relation to valuation allowances and tax rate changes.
Restatement: Restatement refers to the process of revising previously issued financial statements to correct errors or reflect changes in accounting principles. This action ensures that financial reporting remains accurate and reliable, particularly when there are adjustments to tax rates or valuation allowances that affect the financial position of a company. Restatements help maintain transparency and trustworthiness in financial disclosures, which is essential for investors and stakeholders.
Tax rate reconciliation: Tax rate reconciliation is the process of comparing and reconciling the effective tax rate a company reports on its financial statements with the statutory tax rate imposed by the government. This process reveals differences between the expected tax expense based on the statutory rate and the actual tax expense recorded, often due to various factors such as permanent differences, temporary differences, and tax credits. Understanding this reconciliation helps in assessing a company's tax strategies and overall financial health.
Valuation Allowance for Deferred Tax Assets: A valuation allowance for deferred tax assets is a reserve established to reduce the carrying amount of deferred tax assets to the amount that is more likely than not to be realized. This allowance reflects the uncertainty about whether a company will generate enough future taxable income to utilize its deferred tax assets, which can arise from temporary differences or carryforwards. Proper assessment of this allowance is essential as it directly impacts a company's income tax expense and overall financial position.
Asc 740
See definition

ASC 740 is the Accounting Standards Codification topic that provides guidance on accounting for income taxes, particularly in how companies recognize, measure, and disclose their income tax obligations and benefits. This standard helps ensure that financial statements accurately reflect a company's tax position, which is crucial for understanding its financial health and future cash flows. ASC 740 includes principles regarding tax rates, the recognition of tax benefits, and adjustments for uncertain tax positions.

Term 1 of 15

Asc 740
See definition

ASC 740 is the Accounting Standards Codification topic that provides guidance on accounting for income taxes, particularly in how companies recognize, measure, and disclose their income tax obligations and benefits. This standard helps ensure that financial statements accurately reflect a company's tax position, which is crucial for understanding its financial health and future cash flows. ASC 740 includes principles regarding tax rates, the recognition of tax benefits, and adjustments for uncertain tax positions.

Term 1 of 15



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© 2025 Fiveable Inc. All rights reserved.
AP® and SAT® are trademarks registered by the College Board, which is not affiliated with, and does not endorse this website.