A valuation allowance is an accounting term that refers to a reduction in the value of an asset or a liability due to uncertainty or potential loss. A valuation allowance is usually recorded as a contra account, which means it is subtracted from the original account balance to show the net value. One of the most common types of valuation allowance is the deferred tax asset valuation allowance, which is used to adjust the value of deferred tax assets on the balance sheet. Deferred tax assets are created when a company has temporary differences between its taxable income and its accounting income, such as net operating losses, tax credits, or deductible expenses. Deferred tax assets represent the future tax benefits that a company expects to realize when these differences reverse. However, deferred tax assets are only valuable if a company can generate enough taxable income in the future to use them. If a company has a history of losses or faces unfavorable market conditions, it may not be able to realize the full value of its deferred tax assets. In that case, the company needs to create a valuation allowance for deferred tax assets to reflect the likelihood of not being able to use them. A valuation allowance for deferred tax assets reduces the value of the deferred tax assets on the balance sheet and increases the income tax expense on the income statement. This makes the financial statements more conservative and realistic, as it prevents the company from overstating its assets and understating its liabilities.
Why Use a Valuation Allowance & How is a valuation allowance determined?
A valuation allowance is used to comply with the accounting principle of conservatism, which states that a company should not overstate its assets or understate its liabilities. A valuation allowance ensures that the assets and liabilities on the balance sheet are reported at their net realizable value, which is the amount that a company expects to receive or pay in the future. A valuation allowance is determined by applying the more likely than not criterion, which means that a company should create a valuation allowance if it is more likely than not (more than 50% probability) that some or all of the deferred tax assets will not be realized. This criterion is based on the weight of available evidence, which includes both positive and negative factors that affect the future taxable income of the company. Some of the positive factors that indicate that a company can realize its deferred tax assets are:
- A history of profitable operations
- A strong market position and growth prospects
- A reversal of existing taxable temporary differences
- Tax planning strategies that can increase taxable income
- Tax loss carryback or carryforward provisions that allow the company to offset its losses against past or future income
Some of the negative factors that indicate that a company may not be able to realize its deferred tax assets are:
- A history of losses or a recent loss
- A decline in market share or demand
- A significant and prolonged difference between taxable income and accounting income
- A change in tax laws or regulations that reduces the tax benefits of deferred tax assets
- A limitation or expiration of tax loss carryback or carryforward provisions
A company should evaluate the weight of available evidence at the end of each reporting period and adjust the valuation allowance accordingly. The valuation allowance should be sufficient to reduce the deferred tax assets to the amount that is more likely than not to be realized.
When to Release a Valuation Allowance
A valuation allowance is not a permanent account. It can be released or reversed when the circumstances that led to its creation change. A company should release a valuation allowance when it is more likely than not that the deferred tax assets will be realized in the future. This can happen when the company becomes profitable, when the temporary differences reverse, or when the company implements tax planning strategies that increase its taxable income. When a company releases a valuation allowance, it increases the value of the deferred tax assets on the balance sheet and decreases the income tax expense on the income statement. This results in a positive impact on the net income and the earnings per share of the company. However, a company should not release a valuation allowance too soon or too aggressively, as it may overstate its assets and understate its liabilities, and violate the principle of conservatism.
How to calculate Valuation Allowance with formulas
The calculation of valuation allowance is not a simple or straightforward process. It requires a lot of judgment and estimation, as well as a thorough analysis of the available evidence. However, a general formula that can be used to calculate the valuation allowance for deferred tax assets is: Valuation Allowance=Deferred Tax Assets×(1−Expected Realization Rate) The expected realization rate is the percentage of the deferred tax assets that the company expects to realize in the future. It can be estimated by using historical data, projections, or other methods. The expected realization rate can vary from 0% to 100%, depending on the level of uncertainty and the weight of available evidence. For example, suppose a company has deferred tax assets of $100,000, which are mainly composed of net operating losses. The company has a history of losses and faces a competitive and uncertain market. The company estimates that its expected realization rate is 40%, based on its projections and tax planning strategies. The valuation allowance for deferred tax assets can be calculated as: Valuation Allowance=$100,000×(1−0.4)=$60,000 This means that the company expects to realize only $40,000 of its deferred tax assets, and needs to create a valuation allowance of $60,000 to reduce the value of the deferred tax assets on the balance sheet.
What is a Deferred Tax Asset Valuation Allowance?
A deferred tax asset valuation allowance is a specific type of valuation allowance that is used to adjust the value of deferred tax assets on the balance sheet. Deferred tax assets are created when a company has temporary differences between its taxable income and its accounting income, such as net operating losses, tax credits, or deductible expenses. Deferred tax assets represent the future tax benefits that a company expects to realize when these differences reverse. However, deferred tax assets are only valuable if a company can generate enough taxable income in the future to use them. If a company has a history of losses or faces unfavorable market conditions, it may not be able to realize the full value of its deferred tax assets. In that case, the company needs to create a deferred tax asset valuation allowance to reflect the likelihood of not being able to use them. A deferred tax asset valuation allowance reduces the value of the deferred tax assets on the balance sheet and increases the income tax expense on the income statement. This makes the financial statements more conservative and realistic, as it prevents the company from overstating its assets and understating its liabilities.
When is a Deferred Tax Asset Valuation Allowance Required?
A deferred tax asset valuation allowance is required when it is more likely than not (more than 50% probability) that some or all of the deferred tax assets will not be realized. This criterion is based on the weight of available evidence, which includes both positive and negative factors that affect the future taxable income of the company. Some of the positive factors that indicate that a company can realize its deferred tax assets are:
- A history of profitable operations
- A strong market position and growth prospects
- A reversal of existing taxable temporary differences
- Tax planning strategies that can increase taxable income
- Tax loss carryback or carryforward provisions that allow the company to offset its losses against past or future income
Some of the negative factors that indicate that a company may not be able to realize its deferred tax assets are:
- A history of losses or a recent loss
- A decline in market share or demand
- A significant and prolonged difference between taxable income and accounting income
- A change in tax laws or regulations that reduces the tax benefits of deferred tax assets
- A limitation or expiration of tax loss carryback or carryforward provisions
A company should evaluate the weight of available evidence at the end of each reporting period and adjust the deferred tax asset valuation allowance accordingly. The deferred tax asset valuation allowance should be sufficient to reduce the deferred tax assets to the amount that is more likely than not to be realized.
Tax Planning Strategies for Deferred Tax Asset Valuation Allowances
A company can use various tax planning strategies to increase its chances of realizing its deferred tax assets and reducing its deferred tax asset valuation allowance. Some of the common tax planning strategies are:
- Accelerating taxable income or delaying deductible expenses to create or increase taxable income in the current or future periods
- Electing tax accounting methods that reduce the difference between taxable income and accounting income, such as the cash basis or the completed contract method
- Generating tax credits or deductions that can be carried back or forward to offset taxable income in the past or future periods, such as research and development credits or charitable contributions
- Entering into transactions that create taxable income or reduce taxable losses, such as asset sales, debt restructuring, or mergers and acquisitions
- Changing the legal structure or the jurisdiction of the company to take advantage of lower tax rates or favorable tax treaties
However, a company should not use tax planning strategies that are artificial, aggressive, or abusive, as they may be challenged by the tax authorities or result in penalties or fines. A company should also consider the economic costs and benefits of the tax planning strategies, as well as the impact on the financial statements and the stakeholders.
Accounting for Valuation Allowances Under ASC 740
ASC 740 is the accounting standard that governs the recognition and measurement of income taxes in the United States. ASC 740 requires a company to account for deferred tax assets and liabilities using the balance sheet approach, which means that a company should recognize the tax effects of the temporary differences between the tax basis and the book basis of its assets and liabilities. ASC 740 also requires a company to assess the need for a valuation allowance for deferred tax assets at the end of each reporting period. A company should create a valuation allowance if it is more likely than not that some or all of the deferred tax assets will not be realized. A company should release a valuation allowance if it is more likely than not that the deferred tax assets will be realized. ASC 740 provides guidance on how to apply the more likely than not criterion and how to evaluate the weight of available evidence. ASC 740 also specifies the disclosure requirements for deferred tax assets, liabilities, and valuation allowances in the financial statements and the notes.
Considerations for Valuation Allowance Analysis
A valuation allowance analysis is a complex and subjective process that requires a lot of judgment and estimation. A company should consider the following factors when performing a valuation allowance analysis:
- The nature and source of the deferred tax assets and the temporary differences that create them
- The tax laws and regulations that affect the tax benefits of the deferred tax assets and the tax rates that apply to them
- The historical and projected taxable income and accounting income of the company and its segments
- The positive and negative evidence that supports or contradicts the realization of the deferred tax assets
- The tax planning strategies that the company can implement to increase its taxable income or utilize its deferred tax assets
- The changes in the business environment, the market conditions, and the economic outlook that may affect the future profitability of the company
- The sensitivity and uncertainty of the assumptions and estimates used in the valuation allowance analysis
- The consistency and reliability of the valuation allowance analysis and the documentation and support for it
A company should perform a valuation allowance analysis at the end of each reporting period and adjust the valuation allowance accordingly. A company should also disclose the significant assumptions and judgments used in the valuation allowance analysis and the impact of the valuation allowance on the effective tax rate and the net income of the company.
Example of Valuation Allowance
To illustrate the concept of valuation allowance, let us consider a simple example. Suppose a company has the following information for the year 2024:
| Item | Amount |
| Accounting Income | $200,000 |
| Taxable Income | $100,000 |
| Tax Rate | 25% |
| Deferred Tax Assets | $50,000 |
| Valuation Allowance | $0 |
The company has deferred tax assets of $50,000, which are mainly composed of net operating losses from the previous years. The company has a history of losses and faces a competitive and uncertain market. The company estimates that its expected realization rate of the deferred tax assets is 20%, based on its projections and tax planning strategies. The company needs to create a valuation allowance for deferred tax assets to reflect the likelihood of not being able to use them. The valuation allowance can be calculated as: Valuation Allowance=$50,000×(1−0.2)=$40,000 The journal entry to record the valuation allowance is:
|
Debit |
Credit |
| Income Tax Expense | $40,000 |
| Valuation Allowance | $40,000 |
The income tax expense and the valuation allowance are reported on the income statement and the balance sheet, respectively. The income statement and the balance sheet of the company are as follows:
|
Income Statement |
|
| Accounting Income | $200,000 |
| Income Tax Expense | ($40,000) |
| Net Income | $160,000 |
|
Balance Sheet |
|
| Deferred Tax Assets | $50,000 |
| Valuation Allowance | ($40,000) |
| Net Deferred Tax Assets | $10,000 |
The company reports a net income of $160,000, which is lower than the accounting income of $200,000, due to the valuation allowance. The company also reports net deferred tax assets of $10,000, which is lower than the gross deferred tax assets of $50,000, due to the valuation allowance.
FAQs about Valuation Allowance
1. What causes a valuation allowance? A valuation allowance is caused by uncertainty or potential loss in the value of an asset or a liability. A valuation allowance is usually created when it is more likely than not that some or all of the deferred tax assets will not be realized in the future. This can happen when a company has a history of losses, faces unfavorable market conditions, or has a significant difference between its taxable income and its accounting income. 2. What is asset valuation allowance? Asset valuation allowance is a general term that refers to any valuation allowance that is applied to an asset account. Asset valuation allowance is used to reduce the value of an asset to its net realizable value, which is the amount that a company expects to receive from selling or using the asset. Asset valuation allowance can be used for various types of assets, such as inventory, accounts receivable, or investments. 3. What is valuation allowance CFA? Valuation allowance CFA is a topic that is covered in the CFA (Chartered Financial Analyst) exam, which is a professional credential for financial analysts and investment professionals. Valuation allowance CFA is part of the financial reporting and analysis section of the exam, which tests the candidates’ knowledge and skills in accounting standards, financial statements, and income taxes. Valuation allowance CFA requires the candidates to understand the concept, calculation, and impact of valuation allowance, especially for deferred tax assets. 4. What is valuation allowance on balance sheet? Valuation allowance on balance sheet is the amount that is subtracted from the gross value of an asset or a liability account to show the net value. Valuation allowance on balance sheet is usually reported as a contra account, which means it has the opposite balance of the original account. For example, if an asset account has a debit balance, the valuation allowance account will have a credit balance. Valuation allowance on balance sheet is used to adjust the value of an asset or a liability to its net realizable value, which is the amount that a company expects to receive or pay in the future. 5. Is valuation allowance a debit or credit? Valuation allowance is a debit or a credit depending on the type of account that it is applied to. If valuation allowance is applied to an asset account, it is a credit, as it reduces the value of the asset. If valuation allowance is applied to a liability account, it is a debit, as it reduces the value of the liability. For example, if a company has deferred tax assets of $100,000 and a valuation allowance of $40,000, the valuation allowance account will have a credit balance of $40,000, and the net deferred tax assets will be $60,000.
