A deferred tax asset is only worth recording to the extent it will reduce future taxes. The valuation allowance is the mechanism that reconciles recorded deferred tax assets with the likelihood of realizing them. For accounting and tax professionals, assessing the need for an allowance is among the most judgment-intensive steps in the income tax provision, and it requires disciplined analysis and documentation.
Overview
Within the recognition and measurement of deferred taxes, deferred tax assets are first recorded for deductible temporary differences, unused losses, and unused credits. A valuation allowance then reduces the gross deferred tax asset to the amount expected to be realized. Under U.S. GAAP, an allowance is required when it is more likely than not that some portion of the deferred tax asset will not be realized. "More likely than not" means a likelihood of more than 50 percent.
The assessment is performed at each reporting date and at the level of the relevant taxing jurisdiction and filing group. It weighs all available evidence, both positive and negative, and gives each piece weight in proportion to how objectively it can be verified. The result is a net deferred tax asset that reflects realistic expectations rather than simply the arithmetic of temporary differences.
Key Considerations
Sources of Taxable Income
Realization depends on future taxable income of the appropriate character and period. The standard framework recognizes four possible sources:
- Reversal of existing taxable temporary differences, which generate taxable amounts against which deductions can be used.
- Future taxable income exclusive of reversing temporary differences and carryforwards.
- Taxable income in prior carryback years, where the tax law permits carryback.
- Tax planning strategies that are prudent, feasible, and within management's control.
Character matters. For example, a capital loss carryforward can generally be used only against capital gains, so ordinary operating income may not support it. Timing also matters, because reversing liabilities must fall in periods that allow the asset's deductions or carryforwards to be used.
Weighing Positive and Negative Evidence
Negative evidence commonly includes a cumulative loss in recent years, a history of expiring carryforwards, unsettled adverse circumstances, and expected losses. Positive evidence may include a strong earnings history, existing contracts or backlog that support future income, appreciated assets with built-in gains, and sales of new products or services. Objectively verifiable evidence carries more weight than forecasts. A cumulative loss position is difficult to overcome, because projections of future profit are subjective and generally cannot outweigh it without substantial objective support.
Forecasting and Scheduling
When the assessment relies on projected income, the forecast should be consistent with the assumptions used for budgets, impairment testing, and other financial reporting. Scheduling the reversal of temporary differences, together with the expiration profile of carryforwards, shows whether deductions will be absorbed before they lapse. Carryforward limitations, such as those following an ownership change, should be factored into the analysis, and the specific rules should be confirmed with tax advisors.
Best Practices
- Inventory deferred tax assets by jurisdiction, type, and expiration date before testing.
- Identify and document each source of taxable income relied upon, and begin with the most objective sources.
- Record positive and negative evidence in a structured memo, with an explanation of how each item was weighted.
- Align forecasts with other management projections and test them for sensitivity to downside scenarios.
- Evaluate tax planning strategies for feasibility, and record the cost of implementing them.
- Reassess at every reporting date, and record changes in the allowance through income tax expense or other appropriate components.
- Involve tax, finance, and operational leaders so that expectations about future profitability are consistent.
- Retain support for review by auditors and for internal control purposes.
- Reconsider the allowance when circumstances change, such as a restructuring, a major contract loss, or a change in the tax law.
- Disclose significant judgments and the changes in the allowance in line with applicable reporting requirements.
Conclusion
The valuation allowance assessment is the final measurement step that ensures deferred tax assets are carried at amounts that can reasonably be realized. A structured, well-documented evaluation of income sources and evidence supports accurate recognition and measurement across the broader framework of deferred tax assets and liabilities within tax accounting.