When to Recognize a Valuation Allowance for a Deferred Tax Asset

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ASC 740 governs how corporations recognize the effects of income taxes on their financial statements under U.S. GAAP. To properly calculate the ASC 740 provision for income taxes, a corporation must first determine the amount of taxes payable or refundable for the current year, and then recognize deferred tax assets and liabilities for the future tax consequences of events recognized in its current financial statement. If the corporation determines that it is more likely than not that a deferred tax asset won’t be recognized, a valuation allowance is recorded against that deferred tax asset.

How do you determine if a valuation allowance is necessary for deferred tax assets

Deferred tax assets – whether resulting from deductible temporary differences, operating loss carryforwards, or tax credits – must be evaluated for recognition. Companies must establish a valuation allowance for any deferred tax asset (or any portion thereof) that is more likely than not – meaning more than 50% likely – to not be recognized upon examination by the taxing authority.

Positive and negative evidence

The recognition standard is highly subjective. When evaluating the likelihood of a deferred tax asset being recognized, a company must consider all available evidence, including historical information and information about events that occur after the year-end but before financial statements are released. This evidence should be assessed according to the relative weight of each piece of information. Evidence may be positive or negative in nature:

• Positive evidence generally supports an opinion that a valuation allowance is not needed.
• Negative evidence suggests that a valuation allowance should be established.

It’s important to use professional judgment when weighing the available positive and negative evidence.

Sources of taxable income

The ability to recognize a deferred tax benefit ultimately depends on sufficient taxable income, of the correct character, within applicable carryforward periods. Generally, such sources of taxable income could be:

• Future reversals of existing taxable temporary differences
• Other sources of future taxable income
• Tax planning strategies

If at least one of these income sources is sufficient to assure that a deferred tax asset is fully realizable, then each income source doesn’t need to be considered individually. However, if the combined sources aren’t sufficient collectively, each should be considered in setting the overall amount of valuation allowance.

History of cumulative losses

It’s difficult to conclude that a valuation allowance is not needed when a company has a history of cumulative losses, particularly if pre-2018 federal net operating losses (NOLs) or any tax credit carryforwards or foreign/state NOLs are expiring unused or have a very narrow window of remaining realization potential. A similar conclusion would be reached for a presently profitable company if prevailing circumstances point to anticipated future losses. The latter situation might result due to general business circumstances or other unsettled circumstances with a potentially unfavorable outcome that could have a long-term adverse impact on future years.

Negative evidence can be mitigated by the presence of positive evidence, such as:

• Substantial firm sales backlogs that are expected to produce taxable income to realize a deferred tax asset
• The presence of substantially appreciated assets that could be liquidated to produce necessary offsetting taxable income
• A history of strong operating results, independent of the “aberration” that produced a loss giving rise to a deferred tax asset under evaluation

ASC 740 doesn’t prescribe a methodology to determine whether cumulative losses in recent years exist. Instead, this concept of a “history of cumulative losses” is based on prevailing practices and procedures. In practice, “recent years” generally has been interpreted to mean the current year and prior two years (for public companies, this is looked at as a rolling 12 quarters), and earnings and losses have been measured based on pretax book income or loss, including results of discontinued operations but excluding the cumulative effects of accounting changes.

Thus, if there are three years of cumulative book losses, book income can no longer be projected, and deferred tax assets can be supported only by reversing deferred tax liabilities. Unsupported deferred tax assets require a valuation allowance for the deferred tax asset that exceeds reversing differences.

Additionally, when a company with a history of accounting losses begins to have income, this “cumulative losses” concept is used to determine if income is again available to support reversing a portion of the previously established valuation allowance.

When there is a substantial valuation allowance compared to income, entities may schedule out income based on the company’s projections, potential product risks, or product lifecycle. For example, a technology company wouldn’t project income beyond a fairly short time horizon due to market changes and technology obsolescence. In any case, the reversal of the valuation allowance is based on a “facts and circumstances” approach.