Valuation allowance is a contra-account to a deferred tax asset account which shows the amount of deferred tax asset with a more than 50% probability of not being utilized in future due to non-availability of sufficient future taxable income.
Valuation allowance is just like a provision for doubtful debts. It decreases the book value of the deferred tax asset to a value which a company expects to realize in future. A deferred tax asset is an asset that represents the higher tax paid in current year due to difference in accounting and tax rules. You recognize deferred tax asset to move a chunk of current year tax expense to future period to better match the tax expense reported in each period with earnings before taxes.
A deferred tax asset must be recognized only if enough taxable income exists resulting in income tax liability. Major sources of taxable income which can be used to absorb deferred tax asset include (a) the reversal of any taxable temporary differences, (b) availability of net operating loss carryback years and (c) additional future earnings supported by existing contracts, sales orders or a history of cyclicality which can be expected to rebound.
Your company has a 40% tax rate and the following temporary differences in 2017:
- Tax depreciation exceeds accounting depreciation by $5 million. You forecast that tax depreciation will be higher than accounting by $2 million in 2018 and in 2019 and 2020, accounting depreciation will exceed tax depreciation by $3 million each.
- Revenue of $3 million which shall be recognized in 2018 is received in 2017 and included in taxable income resulting in a deferred tax asset of $1.2 million.
You do not need to include any valuation allowance in 2017. It is because the differences between tax depreciation and accounting depreciation has resulted in a deferred tax liability of $2 million (=$5 million × 40%) in 2017 which will increase by $0.8 million (=$2 million × 40%) in 2018. Starting in 2019, tax depreciation will be lower than the accounting depreciation thereby generating taxable income which you can offset against the deferred tax asset. Because the available taxable differences far exceed the deferred tax asset that you need to consume, you are almost certain that no deferred tax asset will go wasted. Hence, you don’t need to include any valuation allowance. Even if the reversal of taxable temporary differences was lower than the deductible temporary differences, you can still realize the deferred tax asset if you have a history of operating income and you have no reason to believe that you will suffer a loss in near future large enough to turn the deferred tax asset redundant.