Assessing the Valuation Allowance for Deferred Tax Assets

A valuation allowance is a reserve account on a company’s balance sheet that functions as a contra-asset, meaning it directly reduces the reported value of a company’s deferred tax assets (DTAs). The allowance adjusts the DTA’s carrying value to an amount that management believes is likely to be realized in future periods. Its establishment signals uncertainty about a company’s ability to generate enough future taxable income to use its existing DTAs. Since these assets represent potential future tax benefits that are only valuable if a company is profitable, the allowance prevents the overstatement of assets, providing a more realistic picture of the company’s financial position.

Understanding Deferred Tax Assets and the Valuation Allowance

A deferred tax asset (DTA) represents a future tax deduction for a company. It arises from two main sources: temporary differences between accounting rules and tax laws, and the carryforward of net operating losses (NOLs). For instance, a company might record an expense for estimated warranty costs in its financial statements in one year, but tax law may only permit the deduction when the actual warranty work is performed in a later year. This timing difference creates a DTA.

Another common source of DTAs is a net operating loss. When a company’s tax-deductible expenses exceed its revenues in a given year, it generates an NOL. Tax laws permit the company to carry this loss forward to future years to offset taxable income, thereby reducing its future tax payments. The potential future tax savings from this NOL carryforward is recorded as a DTA on the balance sheet.

The valuation allowance is recorded directly against these DTAs. Its presence indicates doubt that the company will be able to use some or all of its DTAs. If a company has a DTA of $10 million but establishes a valuation allowance of $4 million, it is signaling that it only expects to realize $6 million of that future tax benefit. As confidence in future profitability decreases, the valuation allowance increases, reducing the net DTA shown on the balance sheet.

Determining the Need for a Valuation Allowance

The decision to establish a valuation allowance is governed by Accounting Standards Codification 740. This rule requires companies to assess whether it is “more likely than not” that some or all of their deferred tax assets will not be realized. The “more likely than not” threshold is a probabilistic standard, meaning a valuation allowance is required if there is a greater than 50% chance the DTA will not be used. This assessment is a comprehensive evaluation of all available evidence, both positive and negative, to make a judgment about future profitability.

Negative Evidence

Negative evidence consists of facts and circumstances that suggest a company will not be able to realize its DTAs. A history of cumulative losses in recent years is significant negative evidence that is difficult to overcome. Other forms include:

• Losses expected in the near future, even for a currently profitable company.
• A history of tax credits or loss carryforwards expiring unused.
• Statutory limitations on the annual use of tax attributes, such as a rule limiting NOL deductions.
• Unsettled circumstances that, if resolved unfavorably, could negatively impact future operations.

Positive Evidence

Positive evidence includes factors that support the conclusion that a company will generate enough future taxable income to realize its DTAs. A strong earnings history can be powerful positive evidence, particularly if a recent loss is considered an aberration. Other forms of positive evidence include:

• Existing contracts or a firm sales backlog that will produce sufficient taxable income.
• An excess of appreciated asset value over the tax basis of the company’s net assets.
• Prudent and feasible tax-planning strategies that the company can and will implement to generate taxable income or prevent a DTA from expiring.

Calculating the Valuation Allowance Amount

Once a company determines that a valuation allowance is necessary, it must calculate the specific amount. The allowance should be sufficient to reduce the deferred tax asset to the amount that is more likely than not to be realized. This means the allowance is recorded for the portion of the DTA that is not expected to be used.

The calculation uses the evidence gathered during the assessment phase to project future taxable income. These sources include future reversals of existing taxable temporary differences (deferred tax liabilities) and projections of future income. The analysis often involves scheduling when temporary differences will reverse to determine if deferred tax liabilities will offset the DTAs.

For example, a company with a DTA of $5 million from net operating loss carryforwards might conclude it can only support realizing $3 million through future profits. In this scenario, the company would establish a valuation allowance of $2 million ($5 million DTA – $3 million realizable amount). If a company cannot reliably forecast future income, it must rely more heavily on objective evidence like the scheduling of reversing deferred tax liabilities.

Financial Statement Impact and Disclosures

The establishment or change in a valuation allowance directly impacts a company’s financial statements. On the income statement, the change in the valuation allowance during a period is recorded as a component of income tax expense. When a company establishes or increases its allowance, it records a charge that increases its overall income tax expense. Conversely, if a company’s outlook improves and it reduces or “releases” its allowance, it records a benefit that decreases its income tax expense.

On the balance sheet, deferred tax assets are presented net of the valuation allowance. The valuation allowance is a contra-asset account, so it directly reduces the gross DTA to its net realizable value, ensuring the balance sheet does not overstate assets. Both the gross DTA and the valuation allowance are classified as noncurrent.

Companies must provide detailed disclosures in the footnotes to their financial statements. These disclosures must include the total amount of all deferred tax assets, the total valuation allowance, and the net change in the allowance for the period. Companies also disclose the approximate tax effect of each major type of temporary difference and carryforward that gives rise to the DTAs.