A client with a net operating loss and a growing deferred tax asset asks the question every year: can we keep it on the balance sheet? The answer is a documented weighing of evidence, not a rule of thumb. This guide sets out the standard, the evidence an auditor weighs, the four sources of taxable income, and a worked entry in which a company holds a net deferred tax liability and still needs an allowance. The overview of the topic is in /us/standards/asc-740-valuation-allowance-deferred-tax-assets, and the wider tax provision is in /us/blog/asc-740-income-taxes-private-companies.
What is the standard?
A valuation allowance is required if it is more likely than not, meaning more than 50 percent, that some or all of a deferred tax asset will not be realized. The allowance reduces the asset to the amount that is more likely than not to be realized. It reflects management's judgment on all quantitative and qualitative information, and a fixed percentage of deferred tax assets is not an appropriate approach.
More likely than not is a lower threshold than "probable" in the loss contingency guidance, which is generally taken as about 75 percent (RSM). The evidence can support realization of part of the deferred tax assets and not the rest, for example an allowance on state deferred tax assets only.
Which evidence counts, and how much?
All available evidence, positive and negative, is considered, including historical results and current information about future years. Evidence is weighted by how objectively verifiable it is. Past results generally carry more weight than projections, and management's belief that the assets will be realized is not, by itself, objective positive evidence.
| Negative evidence | Positive evidence |
|---|---|
| A cumulative loss in recent years, which is a significant piece of negative evidence that is difficult to overcome | Existing contracts or backlog that will produce enough taxable income, shown to be profitable |
| A history of operating losses | Appreciated assets with value above tax basis |
| Losses expected in early future years | A strong earnings history, with evidence that the loss was an aberration |
| Credit or loss carryforwards that have expired unused |
RSM notes that a cumulative loss in recent years is generally defined as a cumulative loss over a three-year period, and that SEC staff have said it is difficult to avoid a valuation allowance when there is objective negative evidence such as that. It is a starting point, not a bright line. Character matters too: capital loss carryforwards can offset only capital gains, so ordinary income does not support them.
What are the four sources of taxable income?
ASC 740-10-30-18 lists four sources, which RSM orders from most to least objective and verifiable:
- Taxable income in prior carryback years, if the law permits carryback.
- Future reversals of existing taxable temporary differences.
- Tax-planning strategies.
- Future taxable income, excluding reversals and carryforwards.
If one source is enough to realize the asset, the others need not be considered for that conclusion. Each source is still considered to determine the amount of any allowance.
Reversals have limits. The mere existence of taxable temporary differences does not make them a source of income. A taxable difference offsets a deductible difference only if it is similar in character, reverses in the same period and sits in the same jurisdiction (RSM). Future taxable income exclusive of reversals is the most subjective source, because projections are highly judgmental (RSM). If it cannot be supported, the analysis rests on the scheduled reversals alone, as in the worked entry below.
A deferred tax liability with an indefinite reversal pattern, sometimes called a "naked credit" and typical for goodwill or an indefinite-lived intangible, may not be appropriate to offset a deferred tax asset that reverses at a specific time. It can support an indefinite-lived asset such as a post-2017 federal NOL, but not dollar for dollar, because the NOL deduction is limited to 80 percent of taxable income in a year (RSM).
Worked entry
An illustration with round numbers at a 21 percent rate. The company has a three-year cumulative loss and no tax-planning strategies, and management cannot support future taxable income, so only scheduled reversals count. Assume the NOL carries forward indefinitely and offsets 80 percent of taxable income.
| Deferred item | Temporary difference or NOL | Tax effect |
|---|---|---|
| NOL carryforward | 500,000 | 105,000 |
| Deductible differences (accrued liabilities) | 100,000 | 21,000 |
| Gross deferred tax assets | 126,000 | |
| Taxable differences (accelerated depreciation) | 400,000 | (84,000) |
Scheduling the reversals: the $100,000 of deductible differences reverses in year 1, and the $400,000 of taxable differences reverses at $100,000 a year over four years.
- Year 1: $100,000 of taxable reversal less $100,000 of deductions leaves $0 for the NOL.
- Years 2 to 4: $100,000 of taxable income a year, and the NOL absorbs 80 percent, or $80,000 a year, a total of $240,000.
- NOL unused: $500,000 less $240,000 is $260,000, a tax effect of $54,600 that the reversal pattern does not support.
| Account | Debit | Credit |
|---|---|---|
| Income tax expense (deferred) | 54,600 | |
| Valuation allowance | 54,600 |
Balance sheet result:
| Item | Amount |
|---|---|
| Gross deferred tax assets | 126,000 |
| Valuation allowance | (54,600) |
| Deferred tax liability | (84,000) |
| Net deferred tax liability | (12,600) |
The allowance is needed even though the company reports a net deferred tax liability, because the NOL limitation leaves part of the NOL unused over the scheduled reversal years. The 80 percent limitation and Section 382 limits are covered in /us/standards/net-operating-losses-80-percent-limit-section-382.
Audit angle
What the auditor tests:
- The cumulative loss computation. Rebuild three-year pretax results from the audited statements and document how the current year and prior years were combined.
- The scheduling. Obtain the reversal schedule by jurisdiction and character. Check that naked credits are not used to support finite-lived assets.
- Projections. Compare forecasts with history and with budgets. Treat projections that rely on a turnaround without a documented cause as weak evidence, and apply the guidance in /us/standards/au-c-540.
- Tax-planning strategies. Confirm each strategy is documented, feasible and within management's control.
- Release and build. For a change in the allowance, trace it to new evidence in the period, not to a change in management's mood.
Common misstatements: a flat percentage allowance, no allowance despite a three-year cumulative loss, taxable differences counted as income with no scheduling, naked credits used against finite-lived NOLs, and a capital loss carryforward supported by ordinary income.
Questions auditors ask
Can a company with a net deferred tax liability need an allowance?
Yes. When the reversal pattern or an NOL limitation leaves part of the asset unusable, the allowance is still required.
Does a backlog overcome a cumulative loss?
Not automatically. The backlog has to be shown to produce taxable income.
CORAA prepares ready-to-review audit files for US CPA firms from QuickBooks books; you review and sign. See /us.
Sources
- RSM, Accounting for income taxes: valuation allowance, December 2023 overview (four sources, evidence, cumulative losses, indefinite-lived liabilities, scheduling, 80 percent NOL limit): https://rsmus.com/content/dam/rsm/insights/financial-reporting/1pdf/accounting-for-income-taxes-valuation-allowance-updated2025.pdf
- PwC Viewpoint, Income taxes guide, 5.2 Assessing the need for a valuation allowance: https://viewpoint.pwc.com/dt/us/en/pwc/accounting_guides/income_taxes/income_taxes__16_US/chapter_5_valuation__US/52_assessing_the_nee_US.html
- PwC Viewpoint, Income taxes guide, 5.3 Sources of taxable income: https://viewpoint.pwc.com/dt/us/en/pwc/accounting_guides/income_taxes/income_taxes__16_US/chapter_5_valuation__US/53_sources_of_taxabl_US.html
- PwC Viewpoint, Income taxes guide, 5.5 Future reversals of existing taxable temporary differences: https://viewpoint.pwc.com/dt/us/en/pwc/accounting_guides/income_taxes/income_taxes__16_US/chapter_5_valuation__US/55_future_reversals__US.html
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AU-C references are to AICPA Professional Standards, paraphrased here; read the standard itself before relying on a requirement. This page is guidance, not professional advice. Report an error