What is Valuation Allowance?
Valuation allowance is an account that allows firms to preserve the value of their deferred tax assets if they do not believe they will realize their deferred tax assets before the carry-forward period expires. It is a contra account that works similarly to allowance for doubtful accounts.
Relation to Deferred Tax Assets
Valuation allowance is a term that is closely related to deferred tax asset. Deferred tax assets occur when there is a temporary difference between the taxable income and the reported profits during a given period, and the company anticipates a reversal in the temporary difference. The business must generate an adequate taxable income for the reversal to occur. In the event that the business fails to generate sufficient taxable income, the deferred tax asset will not be reversed.
According to the US GAAP, if there is a more than 50% probability of a company not realizing the deferred tax asset due to the unavailability of sufficient future taxable income, it is required to create a valuation allowance to reduce the deferred tax asset. Recognizing a valuation allowance results in a corresponding reduction in the deferred tax asset, which increases the income tax expense. A valuation allowance is a contra-asset account that reduces the value of the deferred tax asset to the expected realizable value.
Valuation Allowance Process
Valuation allowance works the same way as allowance for doubtful accounts. It reduces the book value of the deferred tax asset to a value that the company expects to realize at a future date. The company tries to be more conservative by offsetting the decline with a valuation allowance.
For example, a company that is constantly incurring losses in its businesses will have net operating losses over several accounting periods, which will be reported as deferred tax assets. If the company’s future performance projection does not show the likelihood of the business generating profits, it will be difficult to enjoy the benefits of the net operating losses, and it will be forced to set up a valuation allowance to offset the losses.
Since valuation allowance is a non-cash charge, the business’ cash flows will not be affected. A valuation allowance is usually needed when the business expects to incur losses, or it has a history of letting carryforwards expire without being used. If a company believes that it is not going to make enough taxable income to take advantage of deferred tax assets in the future, then it can make a valuation allowance.
The allowance should then be assessed periodically, and it may be increased or decreased if the anticipated income growth changes. Any changes in the allowance should be recorded in the income statement under operating income.
Key Factors in Valuation Allowance
A company should consider several factors when determining whether or not to create a valuation allowance. These factors look at the likelihood of the company being able to utilize its deferred tax assets.
Positive factors suggest that there is no need for a company to set up a valuation allowance. These factors include:
- A history of strong annual earnings in recent years, exclusive of the current year’s deferred tax asset
- Strong evidence of sufficient future taxable income that will realize the benefit of the deferred income tax asset, excluding carry-forwards and temporary reversals
- Strong evidence of sufficient future taxable income resulting from the reversal of current temporary differences or differed tax liabilities to realize the benefit of deferred income tax asset
- Evidence of sufficient taxable income in preceding years that is available for the realization of net operating losses carry-back
- The existence of proper tax planning measures on how the business will realize deferred tax assets
- An appreciation of asset values above their tax bases that would allow a company to realize the deferred income tax assets
Certain events necessitate the creation of a valuation allowance for deferred tax assets. Some of these events include:
- Anticipated future losses: The company may anticipate incurring losses in the future despite a history of net profits in recent years.
- History of operating losses: The company has reported net operating losses in preceding years or has carry-forwards that have expired without being utilized.
- Recent history of losses: The company may have incurred losses in the past and still anticipates the pattern to continue in the future.
Example of Valuation Allowance
Company ABC has accumulated $200,000 in deferred income tax assets after incurring losses for the preceding three years. The company anticipates incurring losses in the current year due to the unfavorable business environment.
If the operating environment remains as it is, the company projects that it is highly unlikely that it will generate sufficient profits in the future, against which the deferred tax assets can be offset. Due to this uncertainty, the company creates a valuation allowance of $200,000 to offset the full book value of the deferred tax assets.
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