What Is a Net Operating Loss Valuation Allowance?

A net operating loss (NOL) valuation allowance is an accounting measure used to reduce the reported value of a company’s deferred tax assets on its balance sheet. This contra-asset account is established when a company determines it is unlikely to generate enough future profit to use its existing tax losses to reduce future tax payments. The purpose of the valuation allowance is to ensure that financial statements do not overstate the value of these potential future tax savings, providing a more realistic picture of the benefits the company can expect to realize.

This mechanism signals to investors and other stakeholders that while a potential tax benefit exists from past losses, its realization is uncertain. The process involves significant judgment and adherence to specific accounting principles to determine when and how large of an allowance is necessary.

The Connection Between NOLs and Deferred Tax Assets

A net operating loss occurs when a company’s tax-deductible expenses are greater than its revenues in a given tax year, resulting in negative taxable income. Instead of paying income taxes for that year, the company accumulates a loss. Tax laws permit companies to carry these losses forward to offset taxable income in future years. This carryforward provision means a current loss can reduce the amount of tax a company will have to pay in subsequent, profitable years.

This anticipated future tax benefit is recognized on a company’s balance sheet as an asset called a deferred tax asset (DTA). The DTA represents the amount of income tax a company expects to save in the future as a result of its current NOLs. The value of the DTA is calculated by multiplying the NOL amount by the applicable corporate tax rate; for instance, a $1 million NOL at a 21% tax rate creates a DTA of $210,000.

This DTA is an asset because it is expected to reduce future cash outflows for taxes. The recognition of a DTA is based on the principle that financial statements should reflect the future effects of transactions that have already occurred. The NOL happened in the current period, and its potential to decrease future taxes is a resource controlled by the company.

When a Valuation Allowance is Required

The requirement to establish a valuation allowance is governed by Accounting Standards Codification (ASC) 740. This guidance mandates that a company must assess the realizability of its deferred tax assets. A valuation allowance is required if, based on all available evidence, it is “more likely than not” that some portion or all of the DTA will not be realized. The “more likely than not” standard means there is a greater than 50% chance the future tax benefit will not be achieved.

Realization of a DTA is dependent on the ability to generate sufficient taxable income in the future. While federal tax rules allow NOLs to be carried forward indefinitely, their use is limited to offsetting 80% of taxable income in any given year. Because of this limitation, if a company does not expect to be consistently profitable enough to use its NOLs, it may not be able to realize the full value of the DTA.

When a company concludes that it is more likely than not that it will fail to generate the necessary future taxable income, it must record a valuation allowance. This allowance reduces the carrying value of the DTA on the balance sheet to the amount that is expected to be realized. For example, if a company has a $210,000 DTA but determines it is only likely to realize $100,000 of that benefit, it must record a valuation allowance of $110,000.

Evaluating Evidence for the Valuation Allowance

The process of determining whether a valuation allowance is necessary involves evaluating all available positive and negative evidence. The weight given to any piece of evidence depends on the extent to which it can be objectively verified.

Negative Evidence

Negative evidence consists of objective information suggesting that a company will not be able to generate sufficient taxable income to realize its DTAs. One of the most persuasive forms of negative evidence is a cumulative history of recent losses. A history of losses in several consecutive years creates a strong presumption that it will continue to incur losses, making it difficult to argue that future profits will materialize.

Other forms of negative evidence include projections showing continued losses in the near future. Unsettled negative business conditions, such as the loss of a major customer, the expiration of a patent, or adverse industry trends, also serve as strong negative evidence. Any objective factor that casts doubt on the company’s ability to return to profitability must be considered.

Positive Evidence

Positive evidence includes objective information that supports the conclusion that a valuation allowance is not needed. This evidence must be compelling enough to overcome the negative evidence. For example, existing and profitable long-term contracts or a substantial sales backlog can provide verifiable proof of future revenue streams, demonstrating that future income is supported by firm commitments.

Another piece of positive evidence is the existence of an excess of appreciated asset value over its tax basis. A company could potentially sell these assets at a gain, generating taxable income that could be used to absorb the NOL carryforwards. A strong history of profitability that makes a recent loss appear to be an aberration or attributable to a specific, non-recurring event can also be persuasive.

Impact on Financial Statements

The decision to record or adjust a valuation allowance has a direct impact on a company’s financial statements. When a valuation allowance is established or increased, the company records a journal entry that debits income tax expense and credits the valuation allowance account. This entry increases the company’s overall income tax expense for the period, which can result in a company reporting a net loss.

On the balance sheet, the valuation allowance is a contra-asset account that is presented as a reduction from the gross DTA. For example, the balance sheet might show a gross DTA of $500,000, a valuation allowance of $200,000, and a resulting net DTA of $300,000. This presentation provides transparency, showing both the total potential tax benefit and the portion management believes is unlikely to be realized.

Companies are also required to provide detailed disclosures in the footnotes to their financial statements. These disclosures explain the nature and amount of the valuation allowance, including the reasons for any significant changes during the period. This narrative provides context, helping investors and analysts understand the judgments and estimates involved in the company’s assessment of its DTAs.