How does a deferred tax asset work, and when do I need a valuation allowance?

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AcadiFi · Accepted Answer

A deferred tax asset represents future tax savings, usually from deductible temporary differences, tax loss carryforwards, or credit carryforwards. The asset is recorded using the enacted tax rate expected to apply when the differences reverse. A valuation allowance is needed if it is more likely than not that some portion of the deferred tax asset will not be realized through future taxable income, carryback potential, or tax planning strategies.

Example: Horizon Beacon Media has a deductible warranty reserve of $300,000 and a tax rate of 25 percent, creating a deferred tax asset of $75,000. It also has a net operating loss carryforward that produces another $125,000 deferred tax asset. Total deferred tax assets are $200,000. Management projects only enough future taxable income to use $150,000 of tax benefits. Because $50,000 is not expected to be realized, the company records a valuation allowance of $50,000 and reports net deferred tax assets of $150,000.

The FAR trap is thinking the allowance changes the tax basis of the underlying items. It does not. It only reduces the reported value of the future tax benefit. A good way to think about it is that the deferred tax asset answers, how much future tax relief exists, while the valuation allowance asks, how much of that relief is actually likely to be usable. Practice more in our CPA FAR question bank.

How does a deferred tax asset work, and when do I need a valuation allowance?

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