Valuation allowance definition
/What is a Valuation Allowance?
A valuation allowance is a reserve that is used to offset the amount of a deferred tax asset. The amount of the allowance is based on that portion of the tax asset for which it is more likely than not that a tax benefit will not be realized by the reporting entity. The assessment is based on both positive and negative evidence, including historical earnings, projected income, tax planning strategies, and industry conditions. If circumstances improve and the company later determines that more of the deferred tax asset will be realized, the valuation allowance can be reversed, increasing net income in that period.
Example of a Valuation Allowance
Spastic Corporation has created $100,000 of deferred tax assets through the diligent generation of losses for the past five years. Based on the company’s poor competitive stance, management believes it is more likely than not that there will be inadequate profits (if any) against which the deferred tax assets can be offset. Accordingly, Spastic recognizes a valuation allowance in the amount of $100,000 that fully offsets the deferred tax assets.
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Controls Over the Valuation Allowance
When developing a valuation allowance for deferred tax assets, organizations should implement the following controls to ensure that a reasonable and justifiable valuation is recorded:
Regular forecasting and monitoring. Establish procedures to regularly assess future taxable income, including revenue projections and profitability trends, to determine whether deferred tax assets will be realized.
Documentation of significant judgments. Require thorough documentation of all key assumptions, estimates, and judgments used in assessing the need for a valuation allowance to ensure transparency and audit readiness.
Review by audit committee. Implement a formal review process where senior management and the audit committee evaluate the reasonableness of the valuation allowance based on historical performance and future expectations.
Consistent application of accounting policies. Ensure that the methodology used to determine the valuation allowance aligns with GAAP or IFRS requirements and is consistently applied across reporting periods.
External audit. Engage external auditors or independent financial experts to review the valuation allowance calculation, providing an objective assessment of its appropriateness.