Explain deferred tax assets and liabilities and the valuation allowance
The idea
A deferred tax liability arises where taxable income is currently below accounting profit and the difference will reverse. A deferred tax asset arises where the reverse holds, or from unused tax losses carried forward. A deferred tax asset is only worth something if there will be future taxable profit to use it against, so under US GAAP a valuation allowance is recorded to reduce it to the amount expected to be realised, while IFRS recognises the asset only to the extent that future taxable profit is probable. Changes in that allowance, or in the asset IFRS recognises, flow through tax expense, which means a more favourable assessment of future taxable profit raises reported earnings directly.
Formulas
Deferred tax on an asset
deferred tax liability = (carrying amount − tax base) × tax rate
- carrying amount
- the asset as reported in the financial statements
- tax base
- what is still deductible against future taxable profit
- tax rate
- the rate expected to apply when the difference reverses
Written for an asset, where a carrying amount above the tax base means tax already deferred and so a liability. The sign flips twice over: below the tax base it is a deferred tax asset, and for a liability the whole relation reverses. Temporary differences only — something taxed in a different period, not something never taxed.
A practice question
What gives rise to a deferred tax asset from tax losses?
- A tax loss carried forward that can reduce future tax payments — correct
- A payment of tax in advanceWhy not: That would be a prepaid tax receivable, a current asset. A loss carryforward is a right to reduce a future bill, not money already handed over.
- An overstatement of current tax expenseWhy not: An overstatement would be corrected, not recognised as an asset.
The loss has value only because it shelters future income. That expected benefit is what the asset represents.
A harder one
What is the purpose of a valuation allowance against a deferred tax asset?
- To increase the asset to its gross amountWhy not: The gross amount is where it starts. The allowance only ever reduces it.
- To reduce the asset to the amount expected to be realised against future taxable profit — correct
- To defer the recognition of current tax expenseWhy not: Current tax is what this period's rules demand and is not deferrable. The allowance concerns the measurement of a deferred tax *asset*.
An asset that can only be used against profits the company may never earn is not worth its gross amount. The allowance writes it down to what is expected to be realised.
The hardest tier
Why is a large release of a valuation allowance worth scrutiny?
- Because it is a cash inflow that inflates operating cash flowWhy not: No cash moves at all. It is a remeasurement of an asset already on the balance sheet.
- Because it always indicates a tax authority disputeWhy not: It indicates a change in the company's own forecast of future taxable profit, which the tax authority plays no part in.
- Because it raises earnings on a forecast alone — correct
The release rests only on management becoming more optimistic about future taxable profit. No transaction has occurred and no cash has moved, so the question is whether the improvement in prospects is real.
In the app: 12 practice questions on this outcome, a narrated walkthrough with diagrams, spaced review that brings it back before you forget it.
Take the free diagnostic →