Valuation Allowance Deferred Tax Asset

What is a valuation allowance for a deferred tax asset, and when is it required? In this CPA exam lecture, Professor Farhat explains the valuation allowance for CPA, CMA, and EA candidates and accounting students — showing why conservatism requires reducing a deferred tax asset when it is more likely than not that it will not be realized, how the contra-asset works, and how it affects income tax expense. Ideal for anyone studying intermediate accounting, accounting for income taxes, and FAR-topic deferred tax assets.
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Video Timeline & Key Concepts:
0:00 — Introduction
0:00-2:15 — Why a deferred tax asset may need a valuation allowance under conservatism
0:07-0:31 — What a deferred tax asset represents
1:29-2:14 — The valuation allowance as a contra-asset, like the allowance for doubtful accounts
2:24-6:10 — Example: calculating the deferred tax asset balance from temporary differences and tax rates
6:12-8:43 — Journal entries for income tax expense, taxes payable, and the deferred tax asset
8:45-10:01 — Applying the valuation allowance when part of the asset is unrealizable
Frequently Asked Questions:
What is a valuation allowance for a deferred tax asset?
A valuation allowance is a contra-asset account that reduces a deferred tax asset to the amount that is expected to be realized. It prevents the balance sheet from overstating the future tax benefit.
When is a valuation allowance required?
It is required when it is more likely than not, meaning a greater than 50 percent chance, that some or all of the deferred tax asset will not be realized. Management weighs positive and negative evidence to make this judgment.
How does the valuation allowance work?
It functions like the allowance for doubtful accounts or an inventory write-down. Rather than reducing the deferred tax asset directly, a contra-asset account is credited to bring the net deferred tax asset down to its realizable value.
How does the valuation allowance affect income tax expense?
Recording a valuation allowance increases income tax expense in the period it is established, because the offsetting debit reduces the net benefit recognized from the deferred tax asset.
How is the net deferred tax asset presented?
The deferred tax asset is reported net of the valuation allowance, so the balance sheet shows only the portion of the future tax benefit that the company expects to actually realize.
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