ASC 740 Valuation Allowance: When and How to Reduce Deferred Tax Assets

Understanding the Valuation Allowance Under ASC 740

A deferred tax asset (DTA) represents the future tax benefit of deductible temporary differences, net operating loss (NOL) carryforwards, and tax credit carryforwards. However, not all deferred tax assets will ultimately be realized. ASC 740-10-30-5 requires that a valuation allowance be established when it is more likely than not (a likelihood of more than 50%) that some portion or all of a deferred tax asset will not be realized. This is one of the most judgment-intensive areas of income tax accounting and a frequent topic on the CPA FAR exam.

The More-Likely-Than-Not Threshold

The more-likely-than-not standard is a relatively low threshold, meaning that if there is even a slight probability (greater than 50%) that a DTA will not be realized, a valuation allowance is needed. The assessment is based on the weight of all available evidence, both positive and negative. Management must use judgment to determine the appropriate amount, considering the relative impact of each piece of evidence.

Positive Evidence Supporting Realization

Positive evidence includes existing contracts or firm sales backlog that will produce more than enough taxable income to realize the DTA, an excess of appreciated asset value over the tax basis sufficient to realize the DTA, a strong earnings history exclusive of the loss that created the deductible temporary difference, and existing taxable temporary differences that will result in taxable income in the periods needed. Objectively verifiable positive evidence, such as existing contracts, generally carries more weight than subjective evidence, such as projections of future income.

Negative Evidence Suggesting Non-Realization

Negative evidence includes cumulative losses in recent years, a history of operating loss or tax credit carryforwards expiring unused, losses expected in early future years, unsettled circumstances that if unfavorably resolved would adversely affect future operations, and a carryback or carryforward period so brief it limits realization. ASC 740 states that forming a conclusion that a valuation allowance is not needed is difficult when there is significant negative evidence, and objectively verifiable negative evidence is difficult to overcome.

Sources of Taxable Income for Realization

ASC 740-10-30-18 identifies four sources of taxable income that support the realization of deferred tax assets:

1. Future reversals of existing taxable temporary differences. When an entity has deferred tax liabilities (DTLs) that will reverse in the same period and jurisdiction as the DTA, those DTLs provide a source of future taxable income. However, the scheduling of reversals must be carefully analyzed because a DTA that reverses in year one provides no benefit if the offsetting DTL does not reverse until year five.
2. Future taxable income exclusive of reversing temporary differences and carryforwards. This includes projected future earnings, but such projections are subjective and receive less weight than objectively verifiable evidence.
3. Taxable income in prior carryback years. Under current law, NOL carrybacks are limited to specific situations (such as farming losses), so this source is less commonly available than it was under prior law.
4. Tax-planning strategies. These are actions that the entity would not ordinarily take but would take to prevent an operating loss or tax credit carryforward from expiring unused, such as accelerating the recognition of taxable income or selling appreciated assets.

Recording and Adjusting the Valuation Allowance

The valuation allowance is a contra-asset account that reduces the gross deferred tax asset to its net realizable value. It is not a direct reduction of the DTA itself. The journal entry to establish a valuation allowance debits income tax expense and credits the valuation allowance. If circumstances change and the valuation allowance is later reduced, the entry is reversed: debit valuation allowance, credit income tax benefit.

The valuation allowance must be reassessed at each reporting date. Changes in the valuation allowance are generally recognized through continuing operations unless the DTA relates to items recorded in other comprehensive income or equity, in which case the change is allocated accordingly.

Impact on Financial Statements

The effective tax rate is directly affected by changes in the valuation allowance. Establishing a valuation allowance increases income tax expense and decreases net income, while releasing a valuation allowance decreases income tax expense and increases net income. Analysts and exam questions frequently focus on the reconciliation of the statutory tax rate to the effective tax rate, where the valuation allowance is a common reconciling item.

Exam Preparation Tips

• Know the four sources of taxable income and how each can support realization of deferred tax assets.
• Understand the weighing of positive and negative evidence, with emphasis on objectively verifiable evidence.
• Practice journal entries for establishing, increasing, decreasing, and releasing valuation allowances.
• Be prepared for questions that require you to calculate the appropriate amount of a valuation allowance based on scheduling of temporary difference reversals.
• Remember that the valuation allowance is a contra-asset, not a direct write-down of the DTA.