A deferred tax asset is created when there is a temporary difference between accounting profits, and the taxable income of the company.
However, the company expects this difference to be reversed in the future with the income they have earned. In the case where there is no sufficient income earned, the deferred tax asset cannot be reversed.
Therefore, companies are required to make this assessment every year, in order to be certain if the income that they earn would be enough to recover the tax asset they had created previously.
However, this can only be done in the case where there is more than 50% of the probability that the deferred tax asset would not be realized.
In this regard, the company is regarded to create a valuation account in order to reduce the deferred tax asset. Upon recognizing the valuation allowance, deferred tax asset is reduced, income tax expense is increased, and there is a subsequent decrease in the net income.
What is a Deferred Tax Valuation Allowance?
Tax often tends to be increasingly complex and confusing for a number of reasons. As a matter of fact, these calculations are often tedious, because of which favorable results are not always obtained as a result.
Consequently, there are other numerous instruments that are formed as a result of this, that ensure that tax payments are made easy, and in the case where there is a miscalculation or an overpayment, that is carried forward to the next subsequent year.
Deferred Tax Valuation Allowance is one such reduction that is allowed to business, in cases where there is a slight discrepancy between the taxes payable as well as the taxes actually paid.
Therefore, a deferred tax asset is referred to as a tax reduction that is incurred in the instance where there are temporary differences as well as carryforwards.
This mostly results in a change in taxes that are payable or refundable in the future periods. In the case where the business has deferred tax assets, they are supposed to create a valuation allowance for deferred tax assets.
However, this account must only be created in the case where there is more than a 50% probability that the company will not realize some portion of the existing asset.
In case of any changes to the existing allowances, the changes are consequently reflected in the income from continuing operations or the income statement.
Regardless of the fact that deferred tax valuation allowance does not stay the same every year, yet it can be seen that it changes and fluctuates from year to year.
Therefore, this is periodically reassessed at continuous intervals, in order to get a clear-cut idea regarding the effective tax rate that the company is liable to pay for the respective year.
Purpose of Valuation of Allowance Account
As mentioned earlier, it can be seen that the valuation of allowance account is mainly utilized in cases of deferred tax assets. Deferred tax asset is considered to be an income inflow into the business.
Therefore, a valuation of allowance account is created as a reserve to account for the likelihood of the deferred tax asset not being realized. This is carried out to the extent where company can be confident that they would not be able to realize the whole amount.
In the case where the higher management and accountants see that the whole net amount is not realizable, the valuation allowance against deferred tax assets is set up.
Therefore, the valuation of allowance account is termed as a contingency account that is based on the likelihood that the deferred tax assets are going to be utilized in the future.
However, there should be reasonable probability that these deferred tax assets are not going to be recovered in the future.
Example of Valuation of Allowance
Kiwi Inc. has managed to create deferred tax assets of $75,000 in the amount of deferred taxes through the diligent losses for the last 4 years.
In the same manner, the higher management has estimated with reasonable assurance that the profitability is unlikely to improve in the coming years.
As a result, they have agreed to recognize a valuation allowance that amounts to $75,000. This allowance is created in order to offset the existing deferred taxes.
Accounting Treatment in the case where Deferred Tax Asset is realized
In the case where it is determined that deferred tax benefits will be realized, the account is reversed and closed down. This implies that there is a decrease in income tax expense as well as an increase in net income.