Valuation allowance
AccountingA write down against a deferred tax asset where it is not probable the company will earn enough profit to use it.
A deferred tax asset is only an asset if it can be used, and using it requires future taxable profit. Where that profit is not probable, the company recognises a valuation allowance, reducing the carrying value of the asset to the amount it expects to realise.
The judgement is deliberately evidence based. A history of recent losses is treated as strong objective evidence against recognition, which is why loss making companies frequently carry allowances against most or all of their accumulated tax losses.
The reversal is where it becomes interesting analytically. When a company returns to sustained profitability and releases the allowance, it books a large one off gain that flows through net income without any cash changing hands and without anything improving that period. Any earnings figure spanning that release needs adjusting.
Under IFRS the mechanism is presented differently, with the asset recognised only to the extent recovery is probable rather than gross with a separate allowance, but the economics and the analytical warning are identical.
Worked example
A gross deferred tax asset of 200, against which a 160 valuation allowance is held, so 40 is carried on the balance sheet.
Two profitable years later, management concludes realisation is now probable and releases the allowance. Net income rises 160 in a single period.
Nothing operational improved that year. Any earnings figure or P/E spanning that release needs the item stripped out.