What Is Valuation Allowance?
A valuation allowance is a contra-asset account used in financial reporting to reduce the carrying amount of deferred tax assets on a company's balance sheet. This allowance is necessary when it is more likely than not that some portion or all of the deferred tax assets will not be realized in the future. It falls under the broader category of accounting and financial reporting standards, specifically related to how companies account for income taxes. The purpose of a valuation allowance is to ensure that deferred tax assets are not overstated, providing a more accurate reflection of a company's financial position. It impacts a company's reported earnings on its income statement when established or adjusted.
History and Origin
The concept of a valuation allowance for deferred tax assets in U.S. Generally Accepted Accounting Principles (GAAP) largely stems from the issuance of Financial Accounting Standards Board (FASB) Statement No. 109, "Accounting for Income Taxes," in February 1992. This standard, which superseded FASB Statement No. 96, established the asset and liability approach for income tax accounting. A core principle of SFAS 109 was the requirement to assess the realizability of deferred tax assets and, if necessary, establish a valuation allowance. The objective was to ensure that deferred tax assets only reflect benefits that are "more likely than not" to be realized. SFAS 109 has since been codified into ASC 740, the current standard for income tax accounting.4
Key Takeaways
- A valuation allowance reduces the carrying value of deferred tax assets on a company's balance sheet.
- It is established when it is "more likely than not" that a deferred tax asset will not be fully realized.
- The determination of a valuation allowance requires significant management judgment and forecasting of future taxable income.
- An increase in the valuation allowance reduces net deferred tax assets and typically results in a corresponding increase in tax expense, impacting current period profitability.
- The reversal of a valuation allowance indicates improved prospects for realizing deferred tax assets and can provide a boost to reported earnings.
Interpreting the Valuation Allowance
Interpreting the valuation allowance involves understanding its implications for a company's current and future financial health. A large or increasing valuation allowance generally signals that a company has accumulated significant deductible temporary differences or net operating losses (NOLs) but faces uncertainty about generating sufficient future taxable income to utilize them. This can be a red flag for investors, as it suggests potential challenges in future profitability or the prolonged utilization of tax benefits.
Conversely, a decrease in the valuation allowance, or its complete reversal, indicates that management and auditors believe the company's prospects have improved sufficiently to realize these tax benefits. This often accompanies a return to sustained profitability or favorable changes in tax law that enhance the likelihood of future reversals of temporary differences.
Hypothetical Example
Consider TechCo, a rapidly growing startup. In its early years, TechCo incurs significant research and development expenses and marketing costs, resulting in pre-tax losses. These losses generate deferred tax assets from deductible temporary differences and net operating loss carryforwards.
In Year 1, TechCo has $10 million in deferred tax assets. However, due to its nascent stage and continued losses, management assesses that it is "more likely than not" that only $2 million of these assets will be realized in the foreseeable future. Therefore, TechCo establishes a valuation allowance of $8 million. This reduces the net deferred tax assets on its balance sheet to $2 million. The corresponding impact is recorded as an increase in tax expense on the income statement, even though no cash taxes are being paid.
In Year 3, TechCo successfully launches a new product line, leading to strong revenue growth and a return to consistent profitability. Given this positive evidence, management reassesses the likelihood of realizing its deferred tax assets. They now project sufficient future taxable income to utilize nearly all of its remaining deferred tax assets. As a result, TechCo reduces its valuation allowance by $7 million, recognizing this reduction as a tax benefit on its income statement. This adjustment boosts reported earnings and reflects the improved outlook for the company's ability to utilize its tax benefits.
Practical Applications
Valuation allowances are prominently featured in the financial statements of companies, particularly those with a history of losses, recent acquisitions, or significant changes in business operations. Investors and analysts scrutinize valuation allowances to gauge the realism of a company's reported deferred tax assets and its underlying financial health.
Public companies must adhere to detailed reporting requirements regarding deferred taxes and valuation allowances. The U.S. Securities and Exchange Commission (SEC) provides guidance through its Financial Reporting Manual, which outlines how registrants should account for and disclose income tax matters, including the need for and measurement of valuation allowances.3 Companies regularly reassess their valuation allowances based on factors like future earnings forecasts, tax planning strategies, and the reversal patterns of temporary differences. Significant adjustments to valuation allowances can have a material impact on reported earnings, making them a key area of focus for corporate finance teams and external auditors. Challenges related to deferred tax assets and valuation allowances continue to be a significant concern for companies, particularly in an environment of changing tax laws and uncertain economic conditions.2
Limitations and Criticisms
One of the primary criticisms of the valuation allowance concept is its inherent subjectivity. The determination of whether deferred tax assets are "more likely than not" to be realized requires significant management judgment and forward-looking assessments of future profitability. This judgment can be influenced by various factors, potentially leading to inconsistencies in application across companies or over time. For instance, companies might be optimistic about their future performance, leading to a delay in recognizing a valuation allowance, or conversely, aggressive in recognizing it to manage earnings.
The subjective nature can also make it challenging for investors to compare companies, as the application of the valuation allowance depends heavily on internal forecasts and qualitative factors. Accounting professionals frequently encounter pitfalls and complexities when applying ASC 740, which governs income tax accounting and includes the valuation allowance.1
Valuation Allowance vs. Deferred Tax Asset
While closely related, a valuation allowance is distinct from a deferred tax asset. A deferred tax asset represents future tax benefits that a company expects to realize due to temporary differences between the book (accounting) and tax bases of assets and liabilities, or from tax carryforwards like net operating losses. These assets arise when a company pays more income tax in the current period than it reports as tax expense on its financial statements, or when it has tax deductions or credits that can be carried forward to offset future taxable income.
In contrast, a valuation allowance is a direct reduction to the deferred tax asset. It is recorded only when it is deemed "more likely than not" (a probability threshold of over 50%) that some or all of the deferred tax asset will not be realized. Essentially, the deferred tax asset represents the gross amount of potential future tax benefits, while the valuation allowance adjusts this amount downward to the net amount expected to be realized. Without a valuation allowance, the deferred tax asset would be presented at its full, unadjusted value, which might overstate the true recoverable benefit.
FAQs
What causes a company to record a valuation allowance?
A company records a valuation allowance when it determines that it is "more likely than not" that it will not generate enough future taxable income to utilize all of its deferred tax assets. Common reasons include a history of losses, projections of future losses, or significant negative evidence about future profitability.
How does a valuation allowance affect a company's financial statements?
When a company establishes or increases a valuation allowance, it reduces the net deferred tax assets on its balance sheet. Simultaneously, it typically increases the tax expense on its income statement in the period of recognition, which reduces net income and, consequently, earnings per share.
Can a valuation allowance be reversed?
Yes, a valuation allowance can be reversed if a company's outlook improves and it becomes "more likely than not" that the deferred tax assets will be realized. Reversing a valuation allowance reduces tax expense, thereby increasing reported earnings in the period of reversal. This often occurs when a company returns to sustained profitability or experiences other positive changes in its business or tax environment.