Deferred tax asset valuation allowance definition
/What is a Deferred Tax Asset Valuation Allowance?
A deferred tax asset valuation allowance is a contra account used to reduce a deferred tax asset to the amount that is more likely than not to be realized. Deferred tax assets arise from deductible temporary differences, net operating loss carryforwards, or tax credit carryforwards. If management concludes that future taxable income may be insufficient to utilize some or all of the deferred tax asset, a valuation allowance is recorded. The allowance increases income tax expense in the period it is established or adjusted. Its purpose is to ensure that the balance sheet reflects only the portion of the deferred tax asset expected to produce future tax benefits.
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Impact of the Valuation Allowance on the Tax Rate
The tax effect of any valuation allowance used to offset the deferred tax asset can also impact the estimated annual effective tax rate. This situation arises when a valuation allowance will result in a business being assigned a different incremental 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.
Disclosure of a Deferred Tax Asset Valuation Allowance
A business might include a disclosure regarding its deferred tax asset valuation allowance in the footnotes that accompany its financial statements. A sample disclosure is as follows:
As of December 31, the Company had total deferred tax assets of $1,250,000, primarily related to net operating loss carryforwards, accrued expenses, and tax credit carryforwards. Management has evaluated the realizability of these deferred tax assets and considered both positive and negative evidence in assessing the likelihood of realization. Based on this assessment, the Company has concluded that it is more likely than not that a portion of the deferred tax assets will not be realized due to insufficient expected future taxable income. As a result, the Company has established a valuation allowance of $450,000 against its deferred tax assets. The net deferred tax asset of $800,000 is expected to be realized through future taxable earnings. The valuation allowance will be reviewed periodically and adjusted as appropriate based on changes in expected future taxable income and other relevant factors.