What does valuation allowance mean on the CPA exam?
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Valuation allowance. The contra account reducing a deferred tax asset to the portion more likely than not to be realized, meaning a likelihood above 50%. Judged on the weight of all available evidence, positive and negative. It never applies to a deferred tax liability.
Defined against ASC 740-10-30-5, 30-17.
Worked example
At December 31, Year 1, a company has deductible temporary differences of $800,000, and the enacted tax rate for the years they reverse is 25%. It has no deferred tax liabilities and no tax-planning strategies. Weighing all the evidence, positive and negative, management judges that only $480,000 of those deductions will more likely than not be used before they expire.
What valuation allowance does the company record?
| Deferred tax asset before any allowance800,000 x 25% | 200,000 |
| Portion more likely than not to be realized480,000 x 25% | 120,000 |
| Valuation allowance200,000 - 120,000 | 80,000 |
Answer: An $80,000 valuation allowance, leaving a net deferred tax asset of $120,000. The $80,000 adds to deferred tax expense for Year 1.
The trap: Using probable, the higher bar from loss contingencies, in place of more likely than not, a likelihood above 50%. A candidate who applies probable writes the asset down further than the standard requires.
Based on ASC 740-10-30-5(e).
Which CPA exam sections use valuation allowance?
Valuation allowance appears in the FAR section of the CPA exam.
Other terms defined against ASC 740-10
- deferred tax asset: A future tax saving created when an item is deducted for accounting before it is deducted for tax, or when a loss can be carried forward.
- deferred tax liability: The deferred tax consequences of taxable temporary differences: income already in the books that the return has not taxed yet, or a deduction taken on the return ahead of the books.
- tax basis: What an asset or liability is worth for tax purposes, which is often not what it is worth for accounting.
- temporary difference: A difference between the tax basis of an asset or liability and its reported amount that will produce taxable or deductible amounts in future years.
Related terms
- allowance for credit losses: The amount set aside for receivables not expected to be collected, estimated over the whole expected life of the asset rather than only once a loss is probable.
- substantial authority: The standard between reasonable basis and more likely than not: roughly a 40 percent chance, judged on the weight of published authorities rather than on the preparer's confidence.
- more likely than not: A greater than 50 percent chance of being sustained on its merits.
- other comprehensive income: Gains and losses that bypass net income and sit in equity until realized, such as unrealized gains on available-for-sale debt securities and foreign currency translation.
- disclaimer of opinion: The auditor states that no opinion is expressed, because they could not get evidence and the possible effect is pervasive.
- treasury stock: A company's own shares reacquired and not retired.