Definition: A valuation allowance is an accounting reserve (contra account) set against deferred tax assets to ensure that their value on the balance sheet accurately reflects the amount that is more likely than not to be realized. It acts as a safeguard, adjusting the deferred tax assets to a level that can be substantiated by future taxable income, thereby maintaining the integrity of financial statements.
In the complex landscape of accounting, understanding the nuances of various financial practices is crucial for accurate reporting and analysis. One such practice, the valuation allowance, plays a pivotal role in ensuring the integrity of an organization’s financial statements, particularly in relation to deferred tax assets.
This article delves into the concept of a valuation allowance, its importance, and its impact on financial reporting.
A valuation allowance is an accounting procedure used to adjust the carrying value of a deferred tax asset. Deferred tax assets arise when a company pays more taxes in advance than it owes in the current period, often due to temporary differences between the accounting and tax treatment of revenue and expenses.
These assets are recognized on the balance sheet and can be used to reduce future tax liabilities. However, if it’s more likely than not that some portion or all of the deferred tax assets will not be realized in future periods, a valuation allowance is set up against them to bring their net value in line with the amount that is expected to be utilized.
Risk Management Tool: Valuation allowance serves as a crucial risk management tool in accounting, ensuring that deferred tax assets are not overstated on the balance sheet by adjusting their value to reflect the amount that can realistically be utilized against future taxable income.
Reflects Financial Prudence: The use of a valuation allowance demonstrates financial prudence, as it requires companies to make a conservative estimation of future profitability and tax position, adhering to the principle of conservatism in financial reporting.
Impacts Financial Statements: Establishing a valuation allowance affects a company’s financial statements by increasing tax expense and reducing net income in the period it’s recognized, and by adjusting the net value of deferred tax assets on the balance sheet, thereby impacting shareholders’ equity.
Imagine a company, ABC Corp, has recognized a deferred tax asset of $100,000 due to net operating losses (NOLs) that it plans to carry forward to offset future taxable income.
However, after evaluating its future income projections and considering both positive and negative evidence, ABC Corp determines there’s only a 50% likelihood that it will generate enough taxable income in the foreseeable future to utilize the entire deferred tax asset.
To reflect this assessment accurately in its financial statements, ABC Corp decides to establish a valuation allowance. Given the 50% likelihood of realization, ABC Corp sets up a valuation allowance of $50,000 against the deferred tax asset.
This adjustment is recorded as an increase in income tax expense on the income statement, reducing net income, and the net deferred tax asset on the balance sheet is now presented as $50,000, aligning the book value with the expected realizable value.
Let’s say ABC Company evaluates its deferred tax assets and decides it’s unlikely to use $20,000 worth of these assets due to projected future losses. To adjust the value on their books, ABC Company would need to record a valuation allowance. Here’s how the journal entry would look:
Journal Entry to Record Valuation Allowance:
Debit: Income Tax Expense $20,000
Credit: Valuation Allowance for Deferred Tax Assets $20,000
This entry increases the income tax expense on the income statement, reflecting the reduction in net income due to the establishment of the valuation allowance. Concurrently, it increases the valuation allowance on the balance sheet, reducing the net value of deferred tax assets.
When a valuation allowance is deemed necessary, it is recorded as an expense on the income statement, specifically within the tax expense section. This reduces net income for the period in which the allowance is established or adjusted.
Conversely, if circumstances change and it becomes more likely that the deferred tax assets will be realized, the valuation allowance can be reduced, resulting in a tax benefit that increases net income.
Recording a valuation allowance involves adjusting the carrying amount of deferred tax assets on the balance sheet to reflect the amount that is more likely than not to be realized in the future. Here’s how it’s done in accounting steps:
Assessment: Begin by assessing the likelihood that the deferred tax assets will not be fully utilized in the future due to insufficient taxable income. This involves reviewing past performance, future income projections, tax planning strategies, and any other relevant factors.
Journal Entry: If it is determined that a portion of the deferred tax assets cannot be realized, a valuation allowance is recorded through a journal entry. The entry increases income tax expense and establishes or increases the valuation allowance. The basic journal entry is:
Debit: Income Tax Expense (to reflect the increase in expense on the income statement)
Credit: Valuation Allowance for Deferred Tax Assets (to establish or increase the allowance on the balance sheet)
This entry does not affect cash flow directly but impacts the net income and the equity section of the balance sheet through retained earnings.
On the balance sheet, the valuation allowance is shown as a deduction from the deferred tax assets, reducing their net value.
On the income statement, the debit to income tax expense due to the valuation allowance reduces the net income for the period.
Disclosure: Companies should disclose their accounting policies regarding deferred tax assets and valuation allowance in the notes to the financial statements. This includes the reasons for establishing the allowance, the amount recognized, and any changes during the reporting period.
Reversal: If in future periods it becomes more likely than not that more deferred tax assets will be realized than previously estimated, the valuation allowance can be decreased through a similar journal entry, but with the debit going to the valuation allowance and the credit to income tax expense, thereby reducing the expense and increasing net income.
The process of recording a valuation allowance requires judgment and periodic reassessment to ensure that the balance sheet accurately reflects the recoverable value of deferred tax assets.
The decision to establish a valuation allowance involves significant judgment and consideration of both positive and negative evidence. Factors influencing this decision include:
You should consider releasing a valuation allowance when there is sufficient positive evidence indicating that it is more likely than not (>50% likelihood) that the deferred tax assets will be realized in the future. This decision is typically based on a combination of factors, including:
Sustained Profitability: Evidence of recent and projected future profitability in the tax jurisdictions where the deferred tax assets are recorded. This suggests that the company will generate sufficient taxable income against which the deferred tax assets can be utilized.
Reversal of Temporary Differences: If temporary differences that previously contributed to deferred tax assets are expected to reverse in such a manner that they will create taxable income, this can justify the release of a valuation allowance.
Feasible Tax Planning Strategies: Implementation of tax planning strategies that would enable the realization of deferred tax assets in the foreseeable future.
Improved Market and Economic Conditions: Changes in the market or economic conditions that positively affect the business operations and financial outlook, increasing the likelihood of realizing deferred tax assets.
The decision to release a valuation allowance should be thoroughly documented and supported by detailed analyses and forecasts. Additionally, changes in valuation allowance, including releases, must be disclosed in the financial statements’ notes, explaining the reasons and financial impact.
The valuation allowance is critical for several reasons:
Ensures Accurate Financial Reporting: It helps ensure that deferred tax assets are not overstated on the balance sheet, reflecting a more accurate picture of an organization’s financial health.
Compliance with Accounting Standards: It aligns with Generally Accepted Accounting Principles (GAAP), specifically ASC 740, which requires that companies assess the likelihood of realizing deferred tax assets and adjust their value accordingly.
Risk Management: By conservatively estimating the recoverability of deferred tax assets, companies can better manage financial risks associated with changes in tax laws, business operations, or economic conditions.
The establishment of a valuation allowance can have a significant impact on a company’s financial statements:
Balance Sheet: Reduces the reported value of deferred tax assets, impacting shareholders’ equity.
Income Statement: Increases tax expense and reduces net income in the period the allowance is recognized.
Cash Flow Statement: While the valuation allowance itself does not directly affect cash flows, the underlying reasons for its recognition, such as projected future losses, can influence investors’ and creditors’ perceptions of the company’s financial health.
A valuation allowance is a testament to the principle of conservatism in accounting, ensuring that companies present a realistic view of their financial position and future prospects. It requires careful evaluation of available evidence and prudent judgment, underscoring the importance of rigorous financial analysis and forecasting.
Understanding the dynamics of valuation allowance is essential for anyone involved in financial reporting, tax planning, or investment analysis, as it significantly influences how deferred tax assets are perceived and valued.
A valuation allowance is required when there’s substantial doubt that some or all of a company’s deferred tax assets will not be realized in future periods due to insufficient future taxable income. This assessment is based on current and forecasted financial performance and tax planning strategies.
Recording a valuation allowance increases income tax expense on the income statement, which reduces the company’s net income for the period the allowance is established or adjusted. This reflects a more conservative view of future earnings and tax benefits.
Yes, a valuation allowance can be reversed if changes in circumstances indicate that it’s more likely than not that the deferred tax assets will be realized in the future. This reversal would decrease income tax expense and increase net income in the period it occurs.
Companies determine the amount of valuation allowance by assessing the likelihood that their deferred tax assets will be utilized against future taxable income, considering factors like future earning potential, tax planning strategies, and market conditions. The allowance is set at an amount that brings the deferred tax assets’ carrying value in line with the realistically expected realizable value.
Accounting & CPA Exam Expert
Shaun Conrad is a Certified Public Accountant and CPA exam expert with a passion for teaching. After almost a decade of experience in public accounting, he created MyAccountingCourse.com to help people learn accounting & finance, pass the CPA exam, and start their career.
