How to Calculate a Valuation Allowance

A valuation allowance is a contra-asset account established to reduce the carrying value of deferred tax assets on a company’s balance sheet. It reflects that it is more likely than not that some portion or all of a deferred tax asset will not be utilized to reduce future tax payments. This adjustment provides a more realistic view of a company’s financial position.

Understanding Deferred Tax Assets and Liabilities

Deferred tax assets and liabilities arise from temporary differences between how a company reports its financial results for accounting purposes and how it calculates its taxable income for tax purposes. These differences are known as timing differences because they eventually reverse over time. Deferred tax assets represent future tax savings, while deferred tax liabilities indicate future tax obligations.

A deferred tax asset occurs when taxes paid are greater than the tax liability recognized for accounting, or when a company has deductible amounts that can reduce future taxable income. Common examples include net operating losses (NOLs) that can be carried forward to offset future profits, warranty reserves, and bad debt reserves. These items are recognized as expenses for financial reporting before they are deductible for tax purposes.

Conversely, a deferred tax liability arises when a company reports higher income for financial accounting than for tax purposes in the current period, meaning it has paid less tax currently but will owe more in the future. A frequent cause of deferred tax liabilities is accelerated depreciation for tax purposes compared to straight-line depreciation for financial reporting. This allows a company to deduct more depreciation for tax in early years, reducing current taxable income, but results in lower deductions and higher taxable income in later years.

Assessing the Need for a Valuation Allowance

Determining whether a valuation allowance is needed for deferred tax assets involves an assessment of evidence, both positive and negative. The objective is to conclude if it is “more likely than not” that some portion of the deferred tax asset will not be realized. “More likely than not” means a probability of more than 50%.

Multiple sources of future taxable income can support the realization of deferred tax assets:
Future reversals of existing deferred tax liabilities, which create taxable amounts that can be offset by deferred tax assets.
Future taxable income from business operations, excluding the reversal of temporary differences and carryforwards.
Taxable income in prior carryback years, if permitted by tax law.
Tax planning strategies that management would implement to accelerate taxable amounts or change the character of income.

Positive evidence suggests that deferred tax assets will be realized. This includes a strong earnings history, especially if a past loss was an unusual event. Existing contracts or a firm sales backlog expected to generate sufficient taxable income serve as positive indicators. An excess of appreciated asset value over the tax basis of net assets also supports realization.

Negative evidence indicates that deferred tax assets may not be realized. A history of cumulative losses in recent years is significant negative evidence. Other factors include:
A history of tax credit or net operating loss carryforwards expiring unused.
Expectations of losses in early future years.
Unsettled circumstances that could negatively affect future profitability.
Brief carryback/carryforward periods that limit the utilization of tax benefits.
When weighing evidence, more objective and verifiable information, such as historical financial results, is given greater consideration than subjective forecasts.

Calculating the Valuation Allowance Amount

Once it has been determined that a valuation allowance is necessary, the next step involves calculating its amount. The valuation allowance reduces the deferred tax asset to its estimated net realizable value. This reflects the future tax benefits a company anticipates receiving.

The calculation begins by determining the gross deferred tax assets. Then, based on the assessment of positive and negative evidence, the portion of these deferred tax assets “more likely than not” to be realized is identified. This realizable portion considers the expected future taxable income and any available tax planning strategies.

The valuation allowance is then the difference between the gross deferred tax assets and the amount deemed realizable. For example, if a company has gross deferred tax assets of $500,000, and after assessment, it determines that only $350,000 is “more likely than not” to be realized, the valuation allowance would be $150,000. This $150,000 allowance reduces the reported deferred tax asset balance from $500,000 to $350,000.

On the balance sheet, the valuation allowance is presented as a contra-asset account, directly reducing the gross deferred tax asset. For instance, the financial statement might show “Deferred Tax Asset: $500,000, Less: Valuation Allowance: $150,000, Net Deferred Tax Asset: $350,000.” The creation or increase of a valuation allowance increases income tax expense on the income statement, reducing net income. Conversely, if circumstances improve and a valuation allowance is later reduced or reversed, it results in a decrease in income tax expense and an increase in net income.