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What Is a Valuation Allowance?

A valuation allowance is a financial tool used to adjust the value of a company's deferred tax assets. If it's likely that a portion of these assets won't be realized, a valuation allowance is set aside to reflect this uncertainty, ensuring financial statements present a more accurate picture of a company's fiscal health. How might this impact a company's financial strategy? Continue reading to uncover the implications.
Osmand Vitez
Osmand Vitez

A valuation allowance represents funds set aside for a specific purpose. Among the most common reasons for this allowance include a loss on investments, estimated amounts for uncollectible accounts, and depreciation for fixed assets. Accountants typically post a valuation allowance into a contra account. A contra account falls in the asset account group and resides on a company’s balance sheet. The difference with a contra account is that it has a natural credit balance, which is opposite from regular asset accounts.

Companies make a valuation allowance to adjust an item’s historical value as recorded in the company’s ledger. A contra account relates to an asset account and usually has an account number close to the original. Taken together, the original asset account with a debit balance will net against the contra account with a credit balance. The difference represents the actual value of the item in a current fair value estimate. Each asset item has its own contra account for this process.

Woman posing
Woman posing

Accounts receivable is a common example of a valuation allowance. A company sells goods or services on credit, allowing customers to pay bills over time. Many companies allow customers 30 days to pay off their open accounts receivable balance. Accountants estimate how many open receivables will go uncollected from customers who do not pay their bills. Accountants make an allowance using one of two methods to create this figure.

The percent of sales or percent of receivables are two common valuation allowance methods used for accounts receivable. The former method requires accountants to review previous credit sales to determine how many of them were written off. The percent of receivables method is similar; accountants look at previous receivables written off and create a percentage to apply to current receivables. The bad debt percentage, applied to current open accounts receivables, indicates the valuation allowance for bad debts. Accountants post this figure into a bad debt allowance account, which is a contra asset that nets against current accounts receivable.

Valuation methods for other items, particularly assets, work in a very similar method. Accountants must find the current value of items through estimates or looking at the current market price for items. In most cases, items lose value and need adjustment so a company represents its true financial value. National accounting standards often call this method mark-to-market accounting or fair value accounting. Accountants must stay within these guidelines to ensure they make the proper valuation allowance for assets.

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