I was doing the following VA question and didn’t understand the solution:
From 2015 to 2017, Valuation allowance went from (839,000) in 2015, to (844,000) in 2016 and finally (124,000) in 2017.
The question is: What does the change in valuation allowance for deferred tax assets indicate over the period of three years from 2015-2017?
and the solution is the following:
“Over the given time period, changes in the valuation allowance reduced aggregate income taxes by $1,828,000. The reductions to the valuation allowance were a result of the company being more likely to earn sufficient taxable income to offset the deferred tax assets i.e., the future earnings are expected to increase.”
I don’t get why they say that future earnings will increase, as the VA increased from 2015 to 2017, and increase of VA should decrease future earnings and not increase them? Can anyone explain the logic behind?
Yeah I remember this question and it isn’t really clear what is going on. What you were shown over the 3 years was the change in the valuation allowance entry, specifically that it was reduced by 1.8m. The corresponding journal entry would be that the DTA would increase by 1.8m which based on why we establish a valuation allowance (insufficient taxable income for DTA to reverse being the main reason) would imply we expect higher future net income.
If these were the changes in the valuation allowance for each year - then over the 3 year period it has dropped by a total of $1.807m
The valuation allowance is a balance that offsets the DTA on the balance sheet in US GAAP (much like accumulated depreciation offsets the gross cost of long lived assets). Much like accumulated depreciation, the other side of the entry hits the income statement (as an adjustment to tax expense).
The valuation allowance is set up if the company does not think it can make use of the DTA in the future, as it does not have enough earnings to offset. The allowance reduces the net DTA on the balance sheet, and charges the same amount to income tax expense in the income statement .
The allowance will subsequently be reduced if the company thinks it can use the DTA in the future. A reduction in the valuation allowance will increase the net deferred tax asset and reduce income tax in the income statement.
So what’s happening here is that the company is realizing it expects to make future earnings that are substantial enough to make use of their deferred tax asset, and so decreasing the valuation allowance to reflect that. The decrease in the allowance is credited against tax expense in the income statement hence the reduction in tax expense (as an analogy think of reversing an impairment under IFRS).
So the solution is talking about how their expectations that future earnings would be higher lead them to reduce the valuation allowance, not the effect that the valuation allowance will have on future earnings.