In the past posts in the Income Tax series we have learnt about deferred tax assets and liabilities, tax bases and effect of changes in tax rates. In this post we will learn about valuation allowance for deferred tax assets and its effect on DTA and income statement.
Valuation Allowance for Deferred tax assets
Deferred tax assets must be assessed at each balance sheet date for availability of sufficient future taxable income to realize the deferred tax assets. DTA have value only if there is possibility of having sufficient future taxable income.
In the event the possibility of having sufficient future taxable income to realize the deferred taxes is low, a valuation allowance is created against the DTA as a contra account.
Valuation allowance effect on income statement
The valuation allowance reduces the DTA. Valuation allowance also has an effect on the income statement as it reduces the income in the period it is created.
Deferred tax asset valuation allowance reversal
In the event the possibility of future taxable income increases, the valuation allowance may be reduced through reversal. Release of valuation allowance will increase the DTA and income.
If a company expects to generate future taxable income, valuation allowance may not be necessary. However, if a company has made losses over the past few years, then the company will need to have a valuation allowance.
Recognition and measurement of current and deferred tax
Taxes payable or taxes recoverable are determined based on the applicable tax rates on the balance sheet date. Deferred taxes should be measured at the tax rate that is expected to apply when the asset is realized or liability is settled.
There are different forms of taxes, such as income tax, capital gains tax and secondary tax and also different tax bases for balance sheet items. Which tax laws will apply is determined by how the asset or liability will be settled. It is prudent to use the tax rate and tax base that is consistent with how the tax base is expected to be recovered or settled.
DTA and DTL both must be adjusted for changes in the tax rates. Income taxes and deferred taxes, both must be recognized on the income statement unless, taxes or deferred taxes are charged directly to equity or a possible provision for deferred taxes relates to a business combination.
Carrying amounts of the DTA and DTL should also be assessed. Carrying amounts can change even though there is no change in the temporary differences during the period. Carrying amounts can change due to changes in tax rates, or reassessment of the recoverability of DTA, or changes in the expectation of how an asset will be recovered.
All unrecognized DTA and DTL must be reassessed at the balance sheet date against probable future economic benefits. If a deferred asset is likely to be recovered, it may be appropriate to recognize the related DTA.
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