Valuation Allowance for Deferred Tax Assets

A deferred tax asset is created due to a temporary difference between accounting profits and taxable income and the company expects this difference to reverse in the future with sufficient future taxable income. However, if there is not sufficient taxable income in the future, the DTA cannot be reversed.

For this reason, the company is required to assess every year, the likelihood that there will be sufficient future taxable income which will be used to recover the tax asset. Under US GAAP, if there is a >50% probability that DTA will not be realized, then the company is required to create a valuation allowance to reduce the deferred tax asset.

When a valuation allowance is recognized, there is a corresponding reduction in DTA, increase in income tax expense, and decrease in net income.

If it is subsequently determined that the deferred tax benefit will be realized, then the entry that established the valuation allowance is reversed. This results in a decrease in income tax expense and an increase in net income. Some analysts call this cookie jar accounting.

Note that valuation allowance is used only for DTA. US GAAP does not allow netting of DTA and DTL.

An analyst must scrutinize valuation allowances as a company may use it to manipulate earnings.

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