How Frequently Is the Deferred Tax Valuation Allowance Reevaluated?

Companies often encounter situations where their reported financial income differs from their taxable income, leading to future tax consequences. These differences create what are known as deferred tax assets (DTAs), which represent future tax benefits a company expects to realize, such as reductions in future tax payments. Because the realization of these future tax benefits is not always guaranteed, a valuation allowance may be needed to adjust the DTA to an amount that is more likely than not to be realized.

Understanding Deferred Tax Assets and Valuation Allowances

Deferred tax assets arise from temporary differences between financial reporting of revenues and expenses and their tax treatment. For example, accruing future warranty costs creates a deductible temporary difference, leading to a deferred tax asset when the warranty is paid. Other common sources include bad debt reserves, certain accrued expenses, and differences in depreciation methods.

Deferred tax assets also arise from tax loss carryforwards and tax credit carryforwards. A net operating loss (NOL) can be carried forward to offset future taxable income, reducing future tax payments. Similarly, tax credits, such as research and development credits, may be carried forward if not fully utilized in the current year, representing future tax savings recorded as deferred tax assets.

A valuation allowance acts as a contra-asset account, reducing the gross amount of deferred tax assets to the portion expected to be realized. Its purpose is to ensure a company does not overstate its future tax benefits. The standard for determining if a valuation allowance is needed is whether it is “more likely than not” that some portion or all of the deferred tax assets will not be realized.

If a company concludes it is more likely than not that it will not realize all or a portion of its deferred tax assets, a valuation allowance is established or increased. This adjustment directly reduces the net deferred tax asset reported on the balance sheet. Conversely, if circumstances change and the company determines that previously reserved deferred tax assets will now be realized, the valuation allowance can be reduced or reversed.

Frequency of Reevaluation

The need for and amount of a deferred tax valuation allowance must be reevaluated at each financial reporting period. Publicly traded companies typically reassess their valuation allowances quarterly, while all other companies must do so at least annually. This ongoing assessment is a requirement stemming from accounting standards, specifically FASB Accounting Standards Codification (ASC) Topic 740, “Income Taxes.”

At each reporting date, management must apply the “more likely than not” criterion to all available evidence to determine if the deferred tax assets continue to be realizable. This involves a thorough review of both historical financial performance and future projections. The objective is to determine whether sufficient taxable income will be generated in future periods to utilize the deferred tax assets before they expire, if applicable.

This continuous reevaluation ensures that the financial statements accurately reflect the current estimate of future tax benefits. A change in judgment about the realizability of deferred tax assets, due to new information or changes in circumstances, directly impacts the valuation allowance in the period the change occurs.

Factors Considered in Reevaluation

Determining the need for a valuation allowance involves a detailed assessment of both qualitative and quantitative factors. Management must weigh all available positive and negative evidence to conclude whether it is “more likely than not” that deferred tax assets will be realized.

Four primary sources of taxable income can support the realization of deferred tax assets. The first is future reversals of existing taxable temporary differences, such as deferred tax liabilities, which create taxable income. The second is future taxable income exclusive of reversing temporary differences and carryforwards, representing projected operating profits. A third is taxable income in prior carryback years, if permitted by tax law, such as net operating losses carried back to offset prior taxable income. The fourth involves tax planning strategies that a company can implement to accelerate taxable income or change the character of income; these strategies must be prudent and feasible.

Positive evidence supports the realization of deferred tax assets. Examples include a strong earnings history, particularly consistent profitability in recent years. Reliable projections of future profitability, supported by existing contracts or a firm sales backlog, also provide positive evidence. An excess of appreciated asset value over the tax basis of a company’s net assets can also contribute, as this appreciation could generate taxable income upon sale.

Conversely, negative evidence suggests that a valuation allowance may be needed or increased. Cumulative losses in recent years are a significant piece of negative evidence that is often difficult to overcome. While “recent years” commonly refers to the current and preceding two years, a history of tax loss or credit carryforwards expiring unused also indicates insufficient past taxable income.

Other negative evidence includes expectations of losses in early future years, even for a currently profitable entity, or unsettled circumstances that could adversely affect future operations. Management must weigh all this evidence, recognizing that objective evidence, such as historical financial results, carries more weight than subjective forecasts. The presence of substantial negative evidence necessitates a greater amount of convincing positive evidence to avoid or reverse a valuation allowance.

Impact on Financial Statements

Changes in the deferred tax valuation allowance have direct and noticeable effects on a company’s financial statements. When a valuation allowance is established or increased, it results in an income tax expense on the income statement. This expense reduces the company’s net income for the period. For instance, if a company determines it is “more likely than not” that a $1 million deferred tax asset will not be realized, recording a $1 million valuation allowance will increase tax expense by $1 million.

Conversely, if a company reduces or reverses a valuation allowance, it records an income tax benefit on the income statement. This benefit increases the company’s net income. Reversals occur when positive evidence outweighs negative evidence, indicating that deferred tax assets previously deemed unrealizable are now expected to be realized. For example, if a company reverses a $500,000 valuation allowance, it will recognize a $500,000 tax benefit, boosting its net income.

On the balance sheet, the valuation allowance is presented as a contra-asset account, which means it reduces the gross deferred tax asset. The deferred tax asset is reported at its net realizable value, which is the gross DTA less the valuation allowance. This presentation ensures that the balance sheet reflects only the portion of the deferred tax asset that is expected to provide future tax benefits.

Companies are also required to disclose detailed information about their deferred tax assets and valuation allowances in the notes to their financial statements. These disclosures include the components of deferred tax assets and liabilities, providing transparency into the nature of the temporary differences. Public companies typically provide a tabular reconciliation of their effective tax rate to the statutory federal income tax rate, explaining significant differences, which can include the impact of valuation allowances.