Question

What is the purpose of establishing a valuation allowance for income tax accounting? What theoretical accounting concept does this reflect? What is the impact of this journal entry on the balance sheet and income statement?

Answer 1

Items on a company's balance sheet that may be used to reduce taxable income in the future are called deferred tax assets. The situation can happen when a business overpaid taxes or paid taxes in advance on its balance sheet. These taxes are eventually returned to the business in the form of tax relief. Therefore, overpayment is considered an asset to the company. A deferred tax asset is the opposite of a deferred tax liability, which can increase the amount of income tax owed by a company.

Deferred tax assets are often created due to taxes paid or carried forward but not yet recognized on the income statement. For example, deferred tax assets can be created due to the tax authorities recognizing revenue or expenses at different times than that of an accounting standard. This asset helps in reducing the company’s future tax liability. It is important to note that a deferred tax asset is recognized only when the difference between the loss-value or depreciation of the asset is expected to offset future profit.

• A deferred tax asset is an item on the balance sheet that results from overpayment or advance payment of taxes.
• It is the opposite of a deferred tax liability, which represents income taxes owed.
• A deferred tax asset can arise when there are differences in tax rules and accounting rules or when there is a carryover of tax losses.
• Beginning in 2018, most companies can carryover a deferred tax asset indefinitely.

The simplest example of a deferred tax asset is the carryover of losses. If a business incurs a loss in a financial year, it usually is entitled to use that loss in order to lower its taxable income in the following years. In that sense, the loss is an asset.

There are some key characteristics of deferred tax assets to consider. First, starting in the 2018 tax year, they can be carried forward indefinitely for most companies, but are no longer able to be carried back.

The second thing to consider is how tax rates affect the value of deferred tax assets. If the tax rate goes up, it works to the company’s favor because the assets’ values also go up, therefore providing a bigger cushion for a larger income. But if the tax rate drops, the tax asset value also declines. This means that the company may not be able to use the whole benefit before the expiration date.