A deferred tax asset is a tax reduction whose recognition is delayed due to deductible temporary differences and carryforwards. This can result in a change in taxes payable or refundable in future periods.
A business should create a valuation allowance for a deferred tax asset if there is a more than 50% probability that the company will not realize some portion of the asset. Any changes to this allowance are to be recorded within income from continuing operations on the income statement. The need for a valuation allowance is especially likely if a business has a history of letting various carryforwards expire unused, or it expects to incur losses in the next few years.
The amount of this allowance should be periodically re-assessed. It may be necessary to alter the allowance based on tax laws that restrict the future use of deductible temporary differences.
The tax effect of any valuation allowance used to offset the deferred tax asset can also impact the estimated annual effective tax rate.
Example of a Deferred Tax Asset Valuation Allowance
Spastic Corporation has created $100,000 of deferred tax assets through the diligent generation of losses for the past five years. Based on the company’s poor competitive stance, management believes it is more likely than not that there will be inadequate profits (if any) against which the deferred tax assets can be offset. Accordingly, Spastic recognizes a valuation allowance in the amount of $100,000 that fully offsets the deferred tax assets.