Under ASC 740, Income Taxes, an entity first recognizes a deferred tax asset for every deductible temporary difference and carryforward, then reduces it by a valuation allowance if realization is doubtful. The allowance is one of the most judgmental balances in a tax provision, and it often decides whether a loss-making company shows a tax benefit or none. This page covers the standard's test, the evidence an entity weighs, and the procedures an auditor applies. For the wider provision, see ASC 740 income taxes for private companies and the valuation allowance glossary entry.
What is the test for recording a valuation allowance?
ASC 740-10-30-5(e) requires a valuation allowance when, based on the weight of 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 percent (ASC 740-10-30-17). The allowance must be enough to reduce the asset to the amount that is more likely than not to be realized.
Two points follow from the wording:
- The test is applied to the asset as a whole and to portions of it. An entity can need an allowance against a single carryforward while the rest of the asset is fully supported.
- Considering all available evidence, positive and negative, is mandatory. The entity cannot skip the exercise because the company is currently profitable, and it cannot record an allowance simply because losses have occurred.
Realization means the deferred tax asset will reduce taxes otherwise payable. The taxable income must be of the right character and fall inside the carryback or carryforward period the tax law allows. A capital loss carryforward, for example, can be used only against capital gains.
What are the four sources of taxable income?
ASC 740-10-30-18 lists four possible sources of taxable income to realize a deferred tax asset:
- Future reversals of existing taxable temporary differences.
- Future taxable income exclusive of reversing temporary differences and carryforwards.
- Taxable income in prior carryback years, if the tax law permits carryback.
- Tax-planning strategies.
If one source is enough to support the conclusion that the whole asset is more likely than not realizable, the entity generally does not need to evaluate the others. KPMG's income taxes handbook notes a practical order: start with the least subjective sources, carryback and reversing taxable differences, and move to forecast income last, since a projection of future income is the source that usually calls for the most judgment.
Tax-planning strategies are actions the entity would take, even if it would not otherwise, to realize the benefit. They are not an independent source of income so much as a way of increasing income from the other three, such as accelerating taxable income or switching from tax-exempt to taxable investments.
Under current US federal law, net operating losses arising in tax years beginning after December 31, 2017 cannot be carried back (with narrow exceptions such as certain farming losses), carry forward indefinitely and can offset only 80 percent of taxable income in a year (IRC section 172(a)). That has two effects on the analysis. An indefinite carryforward can be supported by the reversal of a deferred tax liability tied to an indefinite-lived asset, such as non-amortized goodwill or land, whereas a finite-lived carryforward generally cannot. And the 80 percent cap must be modeled, because reversing taxable differences cannot be assumed to absorb the loss dollar for dollar. See net operating losses: the 80 percent limit and Section 382.
What counts as positive and negative evidence?
ASC 740-10-30-21 and 30-22 give examples. They are illustrations, not a checklist, and the presence of one kind of evidence does not by itself dictate the answer.
| Positive evidence | Negative evidence |
|---|---|
| Cumulative earnings in recent years | Cumulative losses in recent years |
| Income of the right character expected, or available by carryback | No expected income of the right character |
| Reversing taxable amounts offset deductible amounts within the permitted period | Reversals do not fall in the permitted period |
| Long carryback or carryforward periods | Short carryback or carryforward periods |
| Prudent and feasible tax-planning strategies | None available |
| Existing contracts or firm sales backlog that produce enough taxable income (30-22) | A history of carryforwards expiring unused |
The weight given to each item must match how objectively it can be verified (ASC 740-10-30-23). A signed contract backlog is more verifiable than a management forecast of recovery.
Why do cumulative losses matter so much?
A cumulative loss in recent years is significant negative evidence that is hard to overcome. ASC 740 does not define "recent years." KPMG's handbook reports that practice generally uses the current year and the two preceding years, measured on pretax book income or loss, and notes that the entity should also think about permanent differences and other comprehensive income. It is not a bright line: three years of cumulative losses does not automatically require an allowance, and the absence of cumulative losses does not automatically remove one. The cause of the losses, such as a one-time impairment, and when in the period they occurred are relevant. Expected improvement from cost cutting, new management or a better industry outlook is usually weak evidence against objective losses. KPMG also states that an entity cannot rely on a rolling twelve-quarter window at an interim date while ignoring forecast losses for the rest of the year.
How are changes in the allowance recorded?
A change in the allowance caused by a change in judgment about future realization is generally recorded in income tax expense from continuing operations in the period of the change. Deferred tax assets and liabilities are classified as noncurrent (ASC 740-10-45-4). For interim periods, ASC 740-270 sets the rules for allocating the effect of a change in judgment about the beginning-of-year allowance. See ASC 740 uncertain tax positions for the related but separate recognition model for tax positions.
Illustrative example
Figures are illustrative. A private company has a 21% federal rate and ignores state taxes. At year end it has:
- a post-2017 federal NOL carryforward of $500,000, a deferred tax asset of $105,000 (500,000 x 21%);
- accrued liabilities not yet deductible of $100,000, a deferred tax asset of $21,000;
- a taxable temporary difference on tax depreciation of $200,000, a deferred tax liability of $42,000.
Total deferred tax assets are $126,000. The company has cumulative pretax losses over the current and two prior years and no taxable income in carryback years. A forecast of profit is the only support offered for the NOL, and the cumulative losses make that forecast insufficient on its own.
Simplifying so that the depreciation difference and the accrued liabilities reverse in the same future year, the reversing items produce net taxable income before the NOL of $200,000 - $100,000 = $100,000. The NOL can offset only 80% of that, or $80,000.
- Supported by reversals: the $21,000 accrued-liability asset, plus the NOL of $80,000 x 21% = $16,800. Total $37,800.
- Valuation allowance: $126,000 - $37,800 = $88,200.
- Check: unsupported NOL of $500,000 - $80,000 = $420,000, and 420,000 x 21% = $88,200.
A real analysis would schedule the reversals over several years, which can support more of the NOL.
What must be disclosed?
ASC 740-10-50-2 requires disclosure of the total of all deferred tax liabilities, the total of all deferred tax assets, the total valuation allowance recognized, and the net change in the valuation allowance during the year. It also requires carryforward amounts and expiration dates (ASC 740-10-50-3), and the portion of the allowance, if any, whose later reversal would be credited directly to contributed capital. An entity that is not a public business entity discloses the types of temporary differences and carryforwards that give rise to significant portions of its deferred tax assets and liabilities, without the tax effect of each type (ASC 740-10-50-6 and 50-8). For income tax rate reconciliation changes, see ASU 2023-09.
What do auditors test?
These are practice procedures, not a list taken from a standard. The allowance is an accounting estimate, so AU-C 540 applies, along with AU-C 500 on evidence.
- Recompute the deferred tax asset and carryforward schedule and agree it to the filed returns and to the provision workbook. The deferred tax rollforward template is a starting point.
- Determine whether cumulative losses exist, using the entity's stated definition of recent years, and see that the definition is consistently applied.
- Read the scheduling of reversals and test the pattern against the underlying asset records. Check that indefinite-lived reversals are not used to support finite-lived carryforwards.
- Compare the forecast of taxable income to budgets, board-approved plans and the company's history of meeting forecasts. Check that the forecast agrees with the one used for impairment and for going concern.
- Check Section 382 limitations after any ownership change, and test the 80% limit on post-2017 NOLs in the model.
- Confirm the disclosure agrees to the schedule.
Frequently asked questions
Is a valuation allowance required after three years of losses?
Not automatically. Cumulative losses are strong negative evidence, but all evidence is weighed and the entity should consider why the losses occurred. Objective positive evidence is needed to overcome them.
Can future taxable income alone support a deferred tax asset?
It can if the evidence is sufficient and objective enough, but it is the source most open to judgment. With cumulative losses, reversing taxable differences and carryback income are the more persuasive sources.
Does the 80 percent limit change the analysis?
Yes. Post-2017 federal NOLs can offset only 80 percent of taxable income each year, so an entity cannot assume that reversals or forecast income absorb the NOL in full.
Where is a release of the allowance recorded?
Generally in income tax expense from continuing operations in the period the judgment changes, subject to the specific rules for business combinations, discontinued operations and interim periods.
Sources
- FASB, Accounting Standards Codification Topic 740, Income Taxes: 740-10-30-5(e), 30-16 through 30-25, 740-10-45-4, 740-10-50-2, 50-3 and 50-6, and Subtopic 740-270. https://asc.fasb.org
- KPMG, Handbook: Income taxes (2025), chapter 4, Valuation of deferred tax assets.
- Internal Revenue Code section 172(a), net operating loss deduction. https://uscode.house.gov
- AICPA, AU-C Section 540, Auditing Accounting Estimates and Related Disclosures.
Related
- ASC 740 income taxes for private companies
- Valuation allowance
- Deferred tax assets and liabilities
- Net operating losses: the 80 percent limit and Section 382
- Income tax provision workbook
CORAA prepares ready-to-review audit files for US CPA firms from QuickBooks books; you review and sign. See /us.
Part of CORAA University · Tax and compliance for CPA firms: related guides, calculators and templates.
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