What would be a scenario under which we would use a valuation allowance. I’m looking for a live example can’t seem to grasp the concept. valuation allowance is a contra account (offset) against deferred tax assets based on the likelihood that these assets will not be realized. For deferred tax assets to be beneficial, the firm must have future taxable income. If it is more likely than not that a portion of deferred tax assets will not be realized, then the deferred tax asset must be reduced by a valuation allowance. It is up to management to defend the recognition of all deferred tax assets. A valuation allowance reduces income from continuing operations. Because an increase (decrease) in the valuation allowance will serve to decrease (increase) operating income, changes in the valuation allowance are a common means of managing earnings. Whenever a company reports substantial deferred tax assets, an analyst should review the company’s financial performance to determine the likelihood that those assets will be realized.
Read the notes on this link http://www.hawkassociates.com/mrypr058.aspx
Interesting link. You can’t get better live example than this.
Valuation allowances are just basic write-downs of deferred tax assets (expected but uncertain future tax benefits from acquired NOLs) on the balance sheet. Say a company acquired a distressed company with accum NOLs of $1M, but the IRS allows you to only use say $200K over the next 7 years in the carryforward, then the $800K balance must be written down as a non-cash write down if the NOLs are most likely to expire unused. I believe FAS 109 deals with this in more detail.
Thank you for both examples they helped