How do deferred tax assets and liabilities arise, and what is a valuation allowance?

Question

AcadiFi · Accepted Answer

Deferred taxes arise because companies follow **two sets of rules**: financial reporting standards (IFRS or GAAP) for their published financial statements, and tax codes for their tax returns. These rules often produce different timing for recognizing income and expenses.

**The Core Concept: Temporary Differences**

A **temporary difference** is a gap between the carrying value of an asset or liability on the balance sheet and its tax base. These differences will reverse over time.

```mermaid
flowchart TD
    A["Carrying Value vs Tax Base"] --> B{"CV > Tax Base?"}
    B -->|"Yes (Asset)"| C["Future Taxable Amount → DTL"]
    B -->|"No (Asset)"| D["Future Deductible Amount → DTA"]
    A --> E{"CV > Tax Base?"}
    E -->|"Yes (Liability)"| F["Future Deductible → DTA"]
    E -->|"No (Liability)"| G["Future Taxable → DTL"]
```

**Example -- DTL from Depreciation:**
Orion Manufacturing buys equipment for $500,000. For financial reporting, it uses straight-line depreciation over 10 years ($50K/year). For taxes, it uses accelerated depreciation: $100K in Year 1.

| | Book | Tax | Difference |
|---|---|---|---|
| Year 1 depreciation | $50,000 | $100,000 | $50,000 |
| Carrying value after Year 1 | $450,000 | $400,000 | $50,000 |

The book carrying value ($450K) exceeds the tax base ($400K), creating a **taxable temporary difference**. At a 25% tax rate, the **DTL = $50,000 x 25% = $12,500**.

**Example -- DTA from Warranty Provisions:**
Orion accrues a $200,000 warranty expense for financial reporting, but the tax authority only allows a deduction when warranty claims are actually paid. The liability's carrying value ($200K) exceeds its tax base ($0), creating a **deductible temporary difference** and a **DTA = $200,000 x 25% = $50,000**.

**Valuation Allowance**

A DTA is only valuable if the company expects to earn enough taxable income in the future to use the deduction. If that is uncertain, US GAAP requires a **valuation allowance** to reduce the DTA:

- **Net DTA on balance sheet = Gross DTA - Valuation Allowance**
- An increase in the valuation allowance is a **negative signal** -- it means management doubts future profitability

**Exam Tip:** If a company suddenly increases its valuation allowance, it may indicate deteriorating earnings expectations. Analysts should investigate why.

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How do deferred tax assets and liabilities arise, and what is a valuation allowance?

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Book	Tax	Difference
Year 1 depreciation	$50,000	$100,000	$50,000
Carrying value after Year 1	$450,000	$400,000	$50,000