Deferred Tax Asset and Its Valuation Allowance [with Case Examples]

If accounting income was greater than taxable income in the year of origination, resulting in a deferred tax liability. If, however, accounting income is less than taxable income, a deferred tax asset results. What is journal entry for deferred tax asset?

Through a case example in this post, I show you how to Journalize deferred tax asset.

Under prior GAAP, the presentation of deferred income tax assets in the balance sheet was constrained or prohibited entirely.  ASC 740 requires that all deferred income tax assets be given full recognition, subject to the possible provision of an allowance when it is determined that this asset is unlikely to be realized.  This approach (providing full recognition on a gross basis, but also providing for a valuation allowance to reduce the recorded asset to the expected realizable amount) conveys the greatest amount of useful information to the users of the financial statements. How the valuation allowance established?

I discuss establishment of valuation allowance of deferred tax asset that expected to be unrealizable too. Enjoy!

Deferred Tax Assets [a Basic Case Example]

Let’s assume Lie Dharma Company had the following information regarding its income for 2009 and 2010:

As I wrote on my previous post [Temporary and Permanent Differences]. Temporary difference no. 1 relates to income earned but not yet received, which is recognized for accounting purposes but not for tax purposes. Temporary difference no. 2 involves the opposite situation—income has been received but not earned.

Deferred Tax Asset Journal entry for 2009 is:

[Debit]. Income Tax Expense = $22.00*) [plug]

[Debit]. Deferred Tax Asset = $1.60**) [STEP 2]

[Credit]. Income Tax Payable = $21.60*** [STEP 1]

[Credit]. Deferred Tax Liability = $2.00**** [STEP 2]

Notes:

*) $110 × 20%

**) $8 × 20%

***) $108 × 20%

****) $10 × 20%

In 2010 the journal entry is:

[Debit]. Income Tax Expense = $21.60

[Debit]. Deferred Tax Liability = $2.00

[Credit]. Income Tax Payable = $22.00

[Credit]. Deferred Tax Asset = $1.60

The “Deferred Tax Asset” account represents a prepayment of taxes.

For example: If accounting income is $200, taxable income is $220, and the tax rate is 20%, then, according to GAAP, the tax should only be $40. Nevertheless, we are forced to pay $44 because IRS has a different set of accounting rules. Thus the extra $4 we are now paying is not an expense of this period (because in this period we only earned $200 under accounting rules), but rather a prepayment of next period’s taxes.

The deferred tax asset for a carryforward is only recognized if it is more likely than not that positive income will be generated in future years.

Valuation Allowance for Deferred Income Tax Assets Expected to Be Unrealizable

In dealing with the question of measurement of the valuation account, FASB could well have been guided by ASC 450, which established the standard for recognizing contingent obligations incurred and impairments of assets.  Under ASC 450, the threshold for recognition of impairment would have been that the impairment was deemed to be “probable” of realization.  FASB rejected the notion of applying that standard to  this measurement situation, and instead developed a new measure, the “more-likely-than-not” criterion.

Under this provision of ASC 740, a valuation allowance is to be provided for that fraction of the computed year-end balances of the deferred income tax assets for which it has been determined that it is more likely than not that the reported asset amount will not be realized. 

As used in this context, “more likely than not” represents a probability of just over 50%.  Since it is widely agreed that the term probable, as used in ASC 450, denotes a much higher probability (perhaps 85% to 90%), the threshold for reflecting an impairment of deferred income tax assets is much lower than the threshold for other assets (i.e., in most cases, the likelihood of a valuation allowance being required is greater than, say, the likelihood that a long-lived asset is impaired). 

If a higher threshold had been set (such as ASC 450’s “probable”), great diversity could have developed in practice as to the amount of valuation allowances offsetting deferred income tax assets, which would not have been consistent with the goal of comparability of financial statements over time and across entities.

Establishment Of A Valuation Allowance [a Case Example]

Assume that Lie Dharma Corporation has a future deductible temporary difference of $60,000 at December 31, 2009.  The tax rate is a flat 34%.  Based on available evidence, management of Lie Dharma Corporation concludes that it is more likely than not that all sources will not result in future taxable income sufficient to realize an income tax benefit of more than $15,000 (25% of the future deductible temporary difference).  Also assume that there were no deferred income tax assets in previous years and that prior years’ taxable income was inconsequential.

At 12/31/09 Lie Dharma Corporation records a deferred income tax asset in the amount of $20,400 ($60,000 × 34%) and a valuation allowance of $15,300 (34% of the $45,000 difference between the $60,000 of future deductible temporary differences and the $15,000 of future taxable income expected to absorb the future tax deduction arising from the reversal of the temporary difference).

The journal entry at 12/31/09 is:

[Debit]. Deferred income tax asset = $20,400  

[Credit]. Valuation allowance = $15,300

[Credit]. Income tax benefit—deferred = $ 5,100

The deferred income tax benefit of $5,100 represents that portion of the deferred income tax asset (25%) that, more likely than not, is realizable.

Assume that at the end of 2010, Lie Dharma Corporation’s future deductible temporary difference has decreased to $50,000 and that Lie Dharma now has a net operating loss carry-forward of $42,000. 

The total of the net operating loss carry-forward ($42,000) plus the amount of the future deductible temporary difference ($50,000) is $92,000.  A deferred income tax asset of $31,280 ($92,000 × 34%) is recognized at the end of 2010.  Also assume that management of Lie Dharma Corporation concludes that it is more likely than not that $25,000 of the tax asset will not be realized.  Thus, a valuation allowance in that amount is required, and the balance in the allowance account of $15,300 must be increased by $9,700 ($25,000 – $15,300).

The journal entry at 12/31/10 is:

[Debit]. Deferred income tax asset = $10,880  

[Credit]. Valuation allowance = $9,700

[Credit]. Income tax benefit—deferred = $ 1,180

The deferred income tax asset is debited $10,880 to increase it from $20,400 at the end of 2009 to its required balance of $31,280 at the end of 2010.  The deferred income tax benefit of $1,180 represents the net of the $10,880 increase in the deferred income tax asset and the $9,700 increase in the valuation allowance.

While the meaning of the more-likely-than-not criterion is clear (more than 50%), the practical difficulty of assessing whether or not this subjective threshold test is met in a given situation remains.  A number of positive and negative factors need to be evaluated in reaching a conclusion as to the necessity of a valuation allowance.  Positive factors (those suggesting that an allowance is not necessary) include:

• Evidence of sufficient future taxable income, exclusive of reversing temporary differences and carry-forwards, to realize the benefit of the deferred income tax asset
• Evidence of sufficient future taxable income arising from the reversals of existing future taxable temporary differences (deferred income tax liabilities) to realize the benefit of the deferred income tax asset
• Evidence of sufficient taxable income in prior year(s) available for realization of a net operating loss carry-back under existing statutory limitations
• Evidence of the existence of prudent, feasible tax planning strategies under management control that, if implemented, would permit the realization of the deferred income tax asset
• An excess of appreciated asset values over their tax bases, in an amount sufficient to realize the deferred income tax asset
• A strong earnings history exclusive of the loss creating the deferred tax asset

While the foregoing may suggest that the reporting entity will be able to realize the benefits of the future deductible temporary differences outstanding as of the balance sheet date.

Certain negative factors must also be considered in determining whether a valuation allowance needs to be established against deferred income tax assets.  These factors include:

• A cumulative recent history of losses
• A history of operating losses, or of net operating loss or tax credit carry-forwards that have expired unused
• Losses that are anticipated in the near future years, despite a history of profitable operations

Thus, the process of evaluating whether a valuation allowance is needed involves the weighing of both positive and negative factors to determine whether, based on the preponderance of available evidence, it is more likely than not that the deferred income tax assets will be realized.

Source: http://accounting-financial-tax.com/2009/08/deferred-tax-asset-and-its-valuation-allowance-with-case-examples/