A valuation allowance reduces a deferred tax asset to the amount more likely than not to be realized. Getting this judgment right is one of the most consequential decisions in the tax provision - and one of the most scrutinized by external auditors. An unnecessary valuation allowance overstates the tax provision. A missing one understates it. The analysis requires weighing all available positive and negative evidence with objective documentation.
"A deferred tax asset shall be reduced by a valuation allowance if, based on the weight of all available evidence, it is more likely than not that some portion or all of the deferred tax asset will not be realized."
"More likely than not" means a likelihood of more than 50%. This is an objective, forward-looking standard that requires weighing all evidence - positive and negative - with appropriate weight given to each item based on the extent to which it can be objectively verified. The entity assesses all evidence in total, not individual pieces in isolation.
Cumulative losses in recent years is the single most powerful piece of negative evidence under ASC 740. ASC 740-10-30-21 states that a cumulative loss in recent years is a significant piece of negative evidence that is difficult to overcome with positive evidence that is uncertain or subjective in nature.
The presumption can be overcome only by objectively verifiable positive evidence. The types of evidence that auditors find most credible include: specific contracts or purchase orders representing future revenue, non-recurring items that caused the historical losses (restructuring charges, write-offs, litigation), material changes in the business model with demonstrated results, or available tax planning strategies with clear mechanical availability (not dependent on future business performance).
ASC 740-10-30-19 permits consideration of tax planning strategies as positive evidence only if they are prudent and feasible actions that an entity ordinarily might not take but would take to prevent an NOL carryforward from expiring unused. Tax planning strategies must be within the entity's control and available to be implemented. The mere existence of a strategy is not sufficient - the entity must be willing and able to implement it.
Common tax planning strategies considered in valuation allowance analyses include: accelerating recognition of income, changing depreciation elections, selling and leasing back appreciated assets to trigger taxable income, and making entity classification elections. The tax cost of the strategy (incremental taxes paid in the near term) must be weighed against the benefit (preservation of the DTA).
The valuation allowance analysis requires scheduling the reversal pattern of existing deferred tax liabilities (which generate taxable income that can absorb DTAs) against the expiration dates of DTAs (particularly NOL and credit carryforwards). If sufficient DTLs reverse before the DTAs expire, no valuation allowance may be needed even in the absence of other positive evidence.
When sufficient positive evidence emerges to conclude that a previously established valuation allowance is no longer needed, ASC 740-10-45-20 requires the reversal to be recorded in income from continuing operations (or in the appropriate component of other comprehensive income or equity if the underlying DTA was originally established through OCI or equity). A valuation allowance reversal is reported in the same line as income tax expense - it reduces the effective tax rate in the period of reversal.
Reversal triggers that auditors look for include: return to sustained profitability for a sufficient period, backlog or contractual commitments providing high confidence in near-term taxable income, or structural changes (asset sales, business dispositions, reorganizations) that eliminate the source of historical losses.