Definition
Under ASC 740, a deferred tax asset is reduced by a valuation allowance if it is more likely than not (greater than 50%) that some or all of it will not be realized. The assessment weighs all available evidence. Four sources of taxable income can support realization: reversals of existing taxable temporary differences, taxable income in carryback years where permitted, tax planning strategies, and future taxable income exclusive of reversals. A cumulative loss in recent years is significant negative evidence that is hard to overcome with forecasts.
Why it matters in an audit or review
Auditors test the schedule of reversals, the reasonableness of forecasts compared with past results, and consistency with going concern and impairment analyses. Changes in the allowance flow through income tax expense. Net operating losses may be limited by Section 382 after ownership changes.
Example
(Illustrative) A company has a $200,000 DTA from NOLs and three years of cumulative losses, with no taxable temporary differences to reverse. Management concludes that none of the four sources of income supports realization and records a full valuation allowance.
Dr Income tax expense 200,000 Cr Valuation allowance 200,000
Common mistakes
- Relying on optimistic projections despite cumulative losses.
- Not reassessing after an ownership change.
Sources
- FASB ASC 740-10-30-16 through 30-25 (valuation allowance; sources of taxable income; evidence)
- IRC section 382 (limitation on net operating loss carryforwards after an ownership change)
Definitions paraphrase AICPA and FASB guidance; read the standard itself before relying on a requirement. Example figures are illustrative. This page is guidance, not professional advice. Report an error