Deferred Tax Asset (DTA) Valuation Allowance

Quick question regarding Valuation Allowances

CFA 2015, FRA, Page 506, Problem #15:

The solution states that “The valuation allowance is taken against deferred tax assets to represent uncertainty that future taxable income will be sufficient to fully utilize the assets”.

What exactly does this mean? My impression was that DTA was created when income tax expense < taxes payable initially, and the DTA is later drawn down when a larger income tax expense in the final period results in cumulative income tax expense = cumulative taxes payable.

Doesn’t this mean that a valuation allowance would be taken against deferred tax assets to represent uncertainty regarding future pretax income (financial statement), instead of future taxable income (tax return)? Or am I just thinking too hard here…

I think you’re over thinking this one. The point is that the DTA will be offset by a valuation allowance to account for the uncertainty surrounding future (pretax) earnings (questionable that they will be sufficient to reverse at least some portion of the DTA).

Your Valuation Allowance is what initially offsets your DTA (when Taxes Payable > Tax Expense). You create a valuation allowance because you believe you won’t be able to eventually realize the DTA (the taxes payable already paid). Therefore, in order to realize the reduction in taxes payable, you need to have taxable income in the future.

What exactly is meant by “realizing the DTA”? I understand DTA is created when taxes payable > income tax expense, so it’s essentially a prepaid tax expense. Is the DTA realized thru a decreased income tax expense later down the road on the financial statements?

I believe it’s realized by future gains on the income statement. Which, unless it’s too late and my brain is fried, would mean an increase in income tax expense on the financial statement. To realize a DTA, you must have taxable income on the income statement which outweighs the amount of taxes payable (Uncle Sam). This is where the valuation allowance account come in. They don’t get too deep in Schweser, so I think you may just be overthinking this one. I do it too, trust me.

This is starting to make a little sense… and I’m just about to drop this topic for a while so I can move on. But just one more question. By future gains do you mean gains as a direct result of the DTA, or just through normal business operations? As in, does the DTA itself cause a gain in the future? Or do you mean that the DTA must be offset by an operating profit that generates enough income tax expense so that it offsets the DTA?

I mean future gains as in normal business operations. So, if Net Income increases, taxes will increase as well (assuming tax rate didn’t decline dramatically). The DTA can be used to offset some of these taxes. The DTA can’t be used unless it’s writing something off, and the company would have to be profitabe for that to occur. Like a carryforward for instance, is useless if the company never has a positive Net Income. So you’re last question is what i mean. At least this is the way I understand it…

Got it. Thank you.