What does it do? I dont really get what the meaning of reversal, temporary and permanent difference too. Can anyone use simple english to explain? Thanks.
contra account to offset a gross amount.
A valuation allowance is a reserve against the likelihood that a deferred tax asset will not be realized(Remember a deferred tax asset is a future cash inflow). To the extent that a company expects to realize the whole amount, no valuation allowance is provided for. However, if a company expects that the whole amount is not realizable, the Valuation Allowance against deferred tax assets is set up. For instance, if due to losses a company does not expect to realize the deferred tax assets, they may set, say, 50% Valuation Allowance against these assets.
The simple way of saying. it is contigency account on the likehood of DTA to be utilised in the future. it is a provision on those DTA that is not likely to be recovered in the future.
The purpose is to give a more clear picture of the true value of a firms assets. If a firm has been losing money and accumulating DTA’s, their reported assets will higher. So imagine a firm that has big losses. Their DTA’s would big too, boosting reported assets. This is fine IF the firm will be able to make use of those assets in future periods of profitability. The DTA would be amortized over the periods of profitability (this would be reflected on the IS). However, say the firm is a dud. Their bleeding cash and are not likely to turn it around. Well in this case, since it is unlikely the firm will ever have periods of profitability, any DTAs the firm has are worthless. Therefore FASB says the firm would have to write down those DTAs immediately. The vehicle to do this is either a one time charge (in an extreme case) or the valuation allowance method for a “going concern”. I believe management has the discretion to set the amount of the valuation allowance. However, they must be able to justify their assumption to their auditors.
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I also had trouble with this. Thank you Gouman, you explained it very well.
Gouman Wrote: ------------------------------------------------------- > The purpose is to give a more clear picture of the > true value of a firms assets. > > If a firm has been losing money and accumulating > DTA’s, their reported assets will higher. So > imagine a firm that has big losses. Their DTA’s > would big too, boosting reported assets. This is > fine IF the firm will be able to make use of those > assets in future periods of profitability. The DTA > would be amortized over the periods of > profitability (this would be reflected on the > IS). > > However, say the firm is a dud. Their bleeding > cash and are not likely to turn it around. Well in > this case, since it is unlikely the firm will ever > have periods of profitability, any DTAs the firm > has are worthless. Therefore FASB says the firm > would have to write down those DTAs immediately. > The vehicle to do this is either a one time charge > (in an extreme case) or the valuation allowance > method for a “going concern”. > > I believe management has the discretion to set the > amount of the valuation allowance. However, they > must be able to justify their assumption to their > auditors. Since the management has the discretion to set the amount, wouldnt it make sense if the management did not write down these DTA and instead make it look profitable?
That should be the case-but as Gouman mentioned, it will have to be justified to the auditors. One of the objectives of auditing is certifying and confirming that realizable assets at the balance sheet represent real amounts, and will realize cash in the future. With respect to DTA, the valuation allowance will be set up as per FASB-even if the firm chose not to, the auditors will pick it up.