ASC 740 Income Taxes: Deferred Tax Asset Valuation Allowance Transaction Explained with Journal Entries

Posted In | ASC Education | Gridlex Academy

Deferred tax assets (DTAs) arise when a company has temporary differences between its financial accounting income and taxable income, resulting in deductible amounts in future periods. ASC 740, Income Taxes, provides guidelines on the recognition, measurement, and presentation of income taxes, including the treatment of deferred tax assets and the need for a valuation allowance. In this article, we will discuss the concept of a deferred tax asset valuation allowance and provide journal entries to help illustrate the accounting treatment.

 

ASC 740: Income Taxes - Overview

ASC 740 requires companies to use the asset and liability method for accounting for income taxes. Under this method, deferred tax assets and liabilities are recognized based on the differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax bases. The deferred tax assets and liabilities are measured using the enacted tax rates expected to apply in the years when the temporary differences reverse.

 

Deferred Tax Asset Valuation Allowance

A valuation allowance is established when it is more likely than not (greater than 50% probability) that some portion or all of the deferred tax assets will not be realized. The valuation allowance reduces the carrying amount of the deferred tax assets to the amount that is more likely than not to be realized.

 

Factors that may indicate the need for a valuation allowance include:

  1. A history of operating losses or tax credit carryforwards.
     

  2. Cumulative losses in recent years.
     

  3. Expiring tax loss or credit carryforwards.
     

  4. Limited future taxable income sources.
     

Journal Entries for Deferred Tax Asset Valuation Allowance

To illustrate the accounting treatment of a deferred tax asset valuation allowance, let's consider the following example:

XYZ Company has recognized a deferred tax asset of $200,000 due to temporary differences. However, management believes that it is more likely than not that only 60% of the deferred tax asset will be realized.

 

Journal entries for recognizing the deferred tax asset and establishing the valuation allowance would be:

  1. Recognition of Deferred Tax Asset:

       Dr. Deferred Tax Asset: $200,000

       Cr. Income Tax Benefit: $200,000

 

The company recognizes the deferred tax asset and records an income tax benefit in the income statement.
 

  1. Establishment of Valuation Allowance:

       Dr. Income Tax Expense: $80,000

       Cr. Valuation Allowance: $80,000

 

The valuation allowance is calculated as 40% (100% - 60%) of the deferred tax asset, which amounts to $80,000. The company records an income tax expense in the income statement and establishes a valuation allowance against the deferred tax asset.

After establishing the valuation allowance, the net deferred tax asset presented in the balance sheet is $120,000 ($200,000 deferred tax asset - $80,000 valuation allowance).

 

Subsequent Adjustments

If there is a change in the estimated realizability of the deferred tax asset, the company should adjust the valuation allowance accordingly. Any increase or decrease in the valuation allowance should be recognized as an adjustment to the income tax expense in the period in which the change occurs.

 

Understanding the treatment of deferred tax assets and valuation allowances under ASC 740 is crucial for companies to accurately report their income tax positions. By assessing the realizability of deferred tax assets and establishing appropriate valuation allowances, companies can ensure that their financial statements reflect the most accurate representation of their income tax obligations and benefits.