Deciding whether a deferred tax asset will be realized is a judgment, and that judgment must rest on evidence. Under the accounting framework for income taxes, entities weigh positive and negative evidence to decide whether a valuation allowance is needed. Knowing how to identify, classify, and weight each type of evidence is central to a defensible conclusion and to the audit support that backs it up.
Overview
A valuation allowance reduces a deferred tax asset to the amount that is more likely than not to be realized. "More likely than not" means a likelihood of more than 50 percent. To reach that conclusion, management considers all available evidence, both favorable and unfavorable, and assesses whether enough future taxable income of the appropriate character will exist to absorb the deductible temporary differences and carryforwards.
Within the broader assessment criteria for valuation allowances, evidence analysis is the step that connects the sources of taxable income to a final conclusion. Positive evidence supports realization. Negative evidence casts doubt on it. The weight assigned to each item should reflect how objectively it can be verified: evidence based on historical facts generally carries more weight than evidence based on forecasts that depend on future events.
Key Considerations
Types of Positive Evidence
Positive evidence indicates that the asset will likely be used. Common examples include:
- A history of taxable income in recent periods, especially stable or growing income
- Existing contracts or a firm sales backlog that will produce taxable income
- Appreciated assets whose sale would generate gains sufficient to use the deductible amounts
- Reversing taxable temporary differences that will offset deductible differences in the same period and jurisdiction
- Available, prudent, and feasible tax planning strategies that management would actually implement
- Evidence that a loss stems from an unusual, nonrecurring cause rather than ongoing operations
Types of Negative Evidence
Negative evidence suggests that realization is doubtful. Typical examples include:
- Cumulative losses in recent years, which is often the most significant and difficult to overcome
- A history of operating losses or tax credit carryforwards expiring unused
- Expectations of losses in the near term
- Unsettled circumstances that, if unfavorably resolved, would adversely affect future operations
- Short carryforward periods or limitations on use, such as restrictions following an ownership change
Weighting and Objectivity
The framework does not prescribe a formula for balancing evidence. Instead, the weight given should be commensurate with the extent to which the evidence can be objectively verified. A recent cumulative loss is a verifiable fact, so it is hard to outweigh with projections alone. Forecasts of future profitability are more persuasive when they are consistent with the plans used for other business purposes, supported by historical accuracy of prior forecasts, and corroborated by contracts or other external information.
Evidence must also be evaluated by jurisdiction and by character. Capital loss carryforwards require capital gain income, and deferred tax assets in one taxing jurisdiction cannot generally rely on income earned in another. Positive evidence that does not match the nature and location of the deductible amounts offers limited support.
Best Practices
- Document every item. Maintain a written analysis listing each piece of positive and negative evidence, its source, and the reasoning behind its assigned weight.
- Start with objective evidence. Evaluate historical results and cumulative income or loss position first, then consider whether forecasts can reasonably overcome any negative indicators.
- Test forecast reliability. Compare past projections to actual results and ensure assumptions align with budgets, impairment tests, and other internal planning.
- Separate by jurisdiction and attribute. Assess each jurisdiction, each type of income, and each carryforward expiration pattern independently.
- Scrutinize tax planning strategies. Confirm that each strategy is within management's control, feasible, and would be undertaken if needed, and record the tax and cost effects.
- Reassess every reporting period. Evidence changes, so update the analysis as new facts emerge and adjust the allowance when the balance of evidence shifts.
- Involve the right stakeholders. Coordinate tax, accounting, finance planning, and legal teams so that inputs are consistent and well supported for auditors.
Conclusion
Positive and negative evidence form the analytical core of every valuation allowance decision for deferred tax assets. By classifying evidence carefully, weighting it according to objectivity, and documenting the reasoning, tax accounting professionals produce conclusions that are consistent with the assessment criteria, transparent to auditors, and responsive to changes in an entity's circumstances.