Question

Discuss some of the positive and negative evidence used to establish the need for a valuation allowance for a tax loss carry-forward. How will the valuation allowance affect the free cash flow forecast? Use news or journal articles to support your answers.

Answer 1

Deferred Tax asset (DTA) provide provide future tax benefit, our taxes will be lowered in the future due to deferred tax assets on the future profits of the company. Valuation allowance is a contra asset account, the firm needs to build an estimate that the firm will generate future profit and set of DTA but to manage the effect the valuation allowance is subtracted from the deferred tax asset in cases where most likely than not the company will never be able to generate the desired profit to set off the entire DTA. In these cases an allowance is prepared to make sure the effect is maintained.

Positive:

• If the Deferred tax asset/liability is not created there will be a huge rise or fall in the income of the company which maybe misleading to the investors. And when it is unsure of the amount that can be set off the allowance will save face by setting away non-realizable vale of DTA.
• The amount is usually decided on the tax difference of the asset or liability to avoid the company a debt for payment of tax on income or huge benefit of tax loss.

Negative:

• It is tedious for an accountant to make a disclosure and maintain the balance on both the sides of the balance sheet as and when they appear. And it is the decision of higher management and so the effect is never similar from company to company.
• The investor who is not so educated on the allowance may misinterpret the effect of the allowance and make hasty decisions. Also this allowance is generally found on the new companies recently set-up incurring huge costs in the early years.

Journal entries

Example:

1. New technology company has incurred a lot of expenses and it didn't do that well and has incurred huge loss of $500,000. And tax rate is 30%; so we have a Deferred tax asset of $150,000. Now it looks like the accountant feels like the company will never be able to make enough profit to set off entire part of this DTA.

so in this case accountant makes a Valuation allowance of $100,000. You can make an allowance of the full amount as well.

Entry: Deferred Tax asset a/c Dr. 100,000

To Income tax expense A/c 100,000

Income Tax Expense A/c Dr. 100,000

To Valuation Allowance A/c 100,000.

When the future profit if realized the entry can be reversed to set off the effect of 40,000 tax expense.

Valuation Allowance A/c Dr. 40,000

To Income tax expense A/c 40,000