Valuation Allowance

Definition

A valuation allowance is a contra asset account used to reduce the carrying amount of deferred tax assets to the amount that is more likely than not to be realized. This allowance is necessary when there is uncertainty about the realization of deferred tax assets due to factors like projected losses or insufficient taxable income in future periods. It ensures that financial statements present a more accurate view of potential future tax benefits.

5 Must Know Facts For Your Next Test

1. Valuation allowances are recorded when it is more likely than not (over 50% probability) that some or all of a deferred tax asset will not be realized.
2. Changes in the valuation allowance are recognized as tax expense or benefit in the income statement, reflecting adjustments based on updated estimates of realizability.
3. If a company becomes profitable after having a valuation allowance, it may reverse the allowance if future taxable income is expected to be sufficient to realize the deferred tax asset.
4. Valuation allowances help prevent overstating the value of deferred tax assets on the balance sheet, ensuring compliance with accounting principles like conservatism.
5. The process of assessing the need for a valuation allowance involves evaluating both positive and negative evidence regarding future taxable income.

Review Questions

• How does a company determine whether to establish a valuation allowance for its deferred tax assets?
  • A company assesses whether to establish a valuation allowance by evaluating whether it is more likely than not that some or all of its deferred tax assets will not be realized. This involves analyzing both positive evidence, such as past profitability, and negative evidence, like current losses or forecasts of continued losses. If the negative evidence outweighs the positive, a valuation allowance may be warranted to reflect this uncertainty in future realizations.
• What impact does the adjustment of a valuation allowance have on a company's financial statements?
  • Adjusting the valuation allowance impacts a company's financial statements by affecting its income tax expense reported on the income statement. An increase in the allowance results in higher tax expense, reducing net income, while a decrease leads to lower tax expense and potentially higher net income. Additionally, these adjustments can influence how investors perceive the company's future profitability and stability based on expected realizability of deferred tax assets.
• Evaluate how changes in economic conditions might affect the need for a valuation allowance on deferred tax assets.
  • Changes in economic conditions can significantly influence a company's future profitability and, consequently, its need for a valuation allowance on deferred tax assets. For example, during an economic downturn, a company's anticipated taxable income might decline, increasing the likelihood that deferred tax assets will not be realized. Conversely, if favorable economic conditions emerge and profitability is projected to improve, the company may reverse its valuation allowance, reflecting newfound confidence in its ability to utilize those deferred tax benefits. This dynamic highlights how external economic factors play a critical role in financial reporting and asset valuation.

Related terms

Deferred Tax Asset:

A deferred tax asset represents taxes that have been paid or carried forward but not yet recognized as an expense in the financial statements, resulting in a potential future tax benefit.

Accounting Income: The income calculated based on accounting standards, which may differ from taxable income due to book-tax differences.

Taxable Income:

The amount of income subject to taxation, which is calculated according to tax laws and regulations, and may differ from accounting income.