What exactly is a valuation allowance? A company will put a contra asset account called a valuation allowance on its balance sheet when it’s expected that a DTA will never be realized. Essentially, the company has paid “too much” taxes on its tax returns and will never be able to take advantage of that on its financial reporting… so what does the valuation allowance actually do for the company?
Actually it’s not that the company has paid “too much” taxes… the DTA is adjusted downwards when it is deemed that the company will not be profitable enough in the near future to realize near future tax savings, which are implied by the original DTA balance. To decrease the DTA balance on the balance sheet, valuation allowance is increased and retained earnings is decreased (to keep your BS balanced). In future years, when company reverts to higher profitability, valuation allowance may be moved back to DTA.
Is it possible to revert the valuation allowance when the firm become profitable? I couldn’t find a reference to it in the books.
Kochunni69, A CPA should opine on your question… but I think the nature of valuation allowances in general (not just for DTA, but for loans, derivatives positions, etc.) is that they can increase or decrease depending on various market and company-specific factors. If it is not possible to revert the allowance back to DTA, then there would be no need for a valuation allowance line item… we would just deduct from DTA item directly, and that would be the end of it. Any thoughts from accountants?
A valuation allowance is recognized if, based on the weight of available evidence, it is more likely than not that some portion or all of the deferred tax asset will not be realized. The valuation allowance is a Contra Account to the DTA (from whatever I have read). and in looking for the Net DTA this is actually (DTA - Valuation Allowance). So this is one of the reasons why we as analysts should be looking at the change in the DTA account, as well as change in the Valuation allowance accounts to determine if the company has been consistent between accounting periods. CP
Got a question: is there any restatement of past earnings? The whole creation of the DTA is from paying more in taxes than what is recognized as an expense on the financial statements–taxes payble is greater than taxes expense, hence the creation of prepaid taxes to balance the equation. When adjustment is made from DTA to valuation allowance, does that not indicate that your past earnings are now biased to the upside?