Accounting for the ASC 740 Valuation Allowance
Examine the key judgments and evidence-based analysis required by ASC 740 to determine if a valuation allowance is needed for deferred tax assets.
Accounting for income taxes under Accounting Standards Codification (ASC) 740 requires recognizing the effects of taxes on financial statements. A component of this standard is the valuation allowance, which adjusts the value of future tax benefits recorded on a company’s balance sheet. The valuation allowance prevents the overstatement of these assets, ensuring they reflect an amount that is realistically expected to be realized. This directly impacts a company’s reported assets and its income tax expense.
The Foundation of a Valuation Allowance
A valuation allowance is linked to a Deferred Tax Asset (DTA), which represents a future tax benefit recorded as an asset on the balance sheet. A DTA signifies that a company has overpaid taxes or incurred expenses for accounting purposes that will reduce its taxable income in a future period. The existence of a DTA implies the company anticipates recovering this benefit by paying less in taxes later.
DTAs are commonly created through Net Operating Loss (NOL) carryforwards. When a business has more tax-deductible expenses than revenues, it generates an NOL that can be carried forward to offset future profits and reduce future tax payments. This future tax saving is the DTA.
DTAs also arise from tax credit carryforwards. If a company earns tax credits but cannot use them in the current year, the unused portion represents a future reduction in taxes owed. Finally, DTAs result from deductible temporary differences. These occur when an expense is recognized for financial reporting in one period but is not deductible for tax purposes until a later period, such as with warranty claims.
Determining the Need for a Valuation Allowance
A company must determine if it is “more likely than not” that some portion, or all, of its DTAs will not be realized. This standard is defined as a likelihood of more than 50 percent. To make this judgment, ASC 740 requires an evaluation of all available positive and negative evidence.
A company must consider four potential sources of future taxable income to support the realization of its DTAs.
- The future reversal of existing taxable temporary differences, which are the opposite of deductible temporary differences and result in future taxable income.
- Projected future taxable income, exclusive of reversing temporary differences. This analysis relies on a company’s internal forecasts, budgets, and business plans.
- Taxable income in prior carryback years. However, changes to federal tax law have generally eliminated this provision for most businesses.
- The implementation of specific tax-planning strategies. These are actions a company could and would take to generate taxable income to realize its DTAs, such as selling an appreciated asset.
In weighing the evidence, objective negative evidence, such as a history of cumulative losses in recent years, is difficult to overcome. Other negative evidence includes a history of DTAs expiring unused or expectations of future losses. Positive evidence that can counteract this includes existing contracts, a strong sales backlog, an excess of appreciated asset value over its tax basis, and a history of strong earnings.
Calculating and Recording the Valuation Allowance
If a company concludes a portion of its DTAs will not be realized, it must calculate the valuation allowance. The allowance should be recorded specifically for the portion of the DTA that is not expected to be realized. For example, if a company has $10 million in DTAs but determines it will only realize $7 million, a valuation allowance of $3 million must be established.
The accounting entry to record a new valuation allowance involves a debit to the Income Tax Expense account and a credit to the Valuation Allowance account. The valuation allowance is a contra-asset account, presented on the balance sheet as a direct reduction from the gross DTA balance. This entry increases the company’s income tax expense and reduces the net carrying value of the DTAs.
The assessment of the valuation allowance is not a one-time event, and companies must re-evaluate the need for it in each reporting period. If circumstances change, the allowance must be adjusted. For instance, if a company that previously had a full valuation allowance returns to profitability, it would release the allowance.
The release of a valuation allowance is recorded by debiting the Valuation Allowance account and crediting Income Tax Expense. This reduces the company’s income tax expense in the period the release is recorded, which can boost reported net income. Conversely, if a company’s financial outlook deteriorates, it may need to increase its valuation allowance, which would increase its income tax expense.
Financial Statement Disclosures
When a valuation allowance exists, ASC 740 mandates specific disclosures in the income tax footnote of a company’s annual financial statements. These disclosures provide transparency to investors about the nature and amount of the company’s DTAs and the judgments involved in assessing their realizability.
Key disclosure requirements include:
- A reconciliation of the valuation allowance balance from the beginning to the end of the period, detailing all significant changes.
- The approximate tax effect of each type of temporary difference and carryforward that gives rise to a significant portion of the DTAs.
- Information regarding the expiration of carryforwards, including the amounts and expiration dates of any NOLs or tax credits.
- The nature of the evidence that led to the conclusion regarding the valuation allowance, discussing the positive and negative evidence that was weighed.