What it means
Deferred tax assets arise when a company has paid or recorded more tax now than its accounts suggest, or has tax losses it can use against future profit. They are recorded because the company expects to pay less tax later.
The asset is only worth something if the company will have enough taxable profit in the future to use it. Each reporting period, management weighs the evidence for and against using the asset.
The standard threshold is more likely than not, meaning a probability above 50%, and if that is not met for some or all of the asset, a valuation allowance is recorded. Evidence that supports using the asset includes a record of profits, signed contracts, and existing taxable temporary differences that will reverse.
Evidence against includes a history of losses, expiring tax losses and uncertain forecasts. Recent losses are usually given more weight than optimistic forecasts.
The allowance is a contra account, which means it sits against the asset and reduces it on the balance sheet. The expense is recorded through income tax expense, so a new allowance lowers profit in the period when it is created.
The tax losses themselves are not lost, and if the outlook improves the allowance can be released, which increases profit. Investors watch valuation allowances closely because they are a sign of what management thinks about future profit.
A large new allowance can be a warning that the business expects continued losses, while a large release can lift earnings without any improvement in cash.
In practice
Real-world examples
Example 1
A biotech company has accumulated losses of $60,000,000 and no product revenue yet. Its tax losses would create a large deferred tax asset, but there is little evidence of future profit. The company records a full valuation allowance so the net asset is zero.
Example 2
A retailer returns to profit after three years of losses and has contracts for next year. Its accountants judge that most of its tax losses will be used within a few years. They release part of the existing allowance, which increases the year's profit.
Example 3
A manufacturing group has losses in one country but profits in another. The tax losses in the first country can only be used there, so the group records an allowance against those losses, even though the group as a whole is profitable.
Think of it
Imagine holding a handful of discount vouchers for a local shop, but the shop is struggling and might close down before you can use them. To be safe, you write down their value to zero in your personal budget until you know the shop will stay open.
Formula
Calculation
Net deferred tax asset = Gross deferred tax asset - Valuation allowance
Valuation allowance = Portion of gross deferred tax asset not more likely than not to be realised
A company has tax losses that give it a gross deferred tax asset of $800,000. Based on its forecasts, management concludes that it is more likely than not that only $500,000 of the asset will be used before the losses expire. Valuation allowance = 800,000 - 500,000 = $300,000. Net deferred tax asset = 800,000 - 300,000 = $500,000. The company records income tax expense of $300,000 in the period, which lowers its profit by the same amount, although no cash leaves the business.Case study
Seen in the real world
Cedar Falls Brewing is an illustrative, fictional craft brewer that lost money for three years while it expanded. It carried a deferred tax asset of $1,200,000 on its balance sheet, based on the tax losses it expected to use once the new brewery reached capacity.
When a major customer cancelled a distribution contract, the auditors questioned whether the company would earn enough taxable profit within the loss expiry period. After reviewing the revised forecast, management concluded that only $700,000 of the asset was more likely than not to be used.
The valuation allowance was 1,200,000 - 700,000 = $500,000, which was charged to income tax expense and turned a small profit into a loss for the year. In the illustrative follow-up, a recovery two years later allowed the company to release the allowance, and profit rose by $500,000 without any new cash coming in.
Watch out
Common mistakes
- Treating a valuation allowance as the loss of the tax losses themselves, when the losses usually remain available for use and the allowance can be reversed.
- Using optimistic forecasts as the main evidence, when a history of losses generally carries more weight.
- Assuming an allowance involves cash, when it is a non-cash accounting entry that changes the balance sheet and the profit figure.
Questions
People also ask
When is a valuation allowance needed?
When it is more likely than not, meaning above a 50% chance, that some or all of a deferred tax asset will not be realised.
Can a valuation allowance be reversed?
Yes, if the outlook improves and more of the asset is expected to be used, the allowance is reduced and the reduction increases profit.
Does a valuation allowance affect the tax return?
No, it is an accounting estimate for the financial statements, and the company's actual tax position is unchanged.