The valuation allowance and the four sources of taxable income

In this lesson you will

Apply the more-likely-than-not threshold to deferred tax assets
Weigh negative and positive evidence by how objectively it can be verified
Measure the allowance using the four sources of taxable income in order of reliability
Account for a change in the allowance in the right period and line

The threshold

Statement 109 paragraph 17(e) requires a valuation allowance if, based on the weight of available evidence, it is more likely than not (a likelihood of more than 50 percent) that some portion 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. The assessment is made by tax-paying component and jurisdiction.

Weighing the evidence

Paragraph 20 requires consideration of all available evidence, positive and negative. Paragraph 25 sets the weighting rule: the weight given to evidence is commensurate with the extent to which it can be objectively verified. The more negative evidence exists, the more positive evidence is needed.

Paragraph 23 names cumulative losses in recent years as negative evidence that makes it difficult to conclude no allowance is needed. Other negative evidence includes:

A history of loss or credit carryforwards expiring unused
Losses expected in early future years by a presently profitable entity
Unsettled circumstances that would hurt future operations if resolved unfavorably
A carryforward period so short it limits realization

Paragraph 24 gives positive evidence examples: existing contracts or backlog that produce enough taxable income, appreciated assets in excess of tax basis, and a strong earnings history apart from a loss shown to be an aberration. A forecast of future profits is evidence too, but it is less objectively verifiable than historical results, so it carries little weight against a recent history of losses.

The four sources

Paragraph 21 says realization depends on sufficient taxable income of the appropriate character within the carryback and carryforward periods, and identifies four possible sources:

Future reversals of existing taxable temporary differences
Future taxable income exclusive of reversing temporary differences and carryforwards
Taxable income in prior carryback years, if carryback is permitted
Tax-planning strategies

If evidence about one source is enough to conclude no allowance is needed, the others need not be considered. To measure the amount of an allowance, each source must be considered.

Reversals and timing. A reversing taxable temporary difference supports a deferred tax asset only if it reverses within the period the asset can be used. Federal net operating losses arising in tax years beginning after 2017 carry forward indefinitely, but 26 U.S.C. 172(a) limits their use to 80 percent of taxable income. A deferred tax liability on an indefinite-lived asset can support such a loss, limited to 80 percent of the reversal.

Tax-planning strategies. Paragraph 22 defines them as actions that are prudent and feasible, that the entity ordinarily might not take, but would take to prevent a carryforward from expiring, and that would result in realization. Significant costs to implement a strategy, net of tax, reduce the benefit. Interpretation 48 paragraph 9 applies the recognition and measurement rules for uncertain positions to the strategy itself.

Changes in the allowance

Paragraph 26 sends the effect of a change in the beginning-of-year allowance caused by a change in judgment about future years to income from continuing operations, with limited exceptions. In an interim period, that effect is excluded from the estimated annual effective tax rate and recorded as a discrete item (ASC 740-270-30-11, as amended by ASU 2019-12).

Audit focus

Read the valuation allowance standard page and the evidence guide for more depth. In the file, look for a scheduled analysis of each source, a three-year cumulative pretax result computed and addressed, and forecasts compared with the history the retrospective review shows.

Worked example

Measuring the allowance for Cobalt Sensor Labs, Inc.

Cobalt Sensor Labs has a three-year cumulative pretax loss and no carryback. At year end it has:

Federal net operating loss carryforward (post-2017, indefinite life): $4,000,000, deferred tax asset 4,000,000 x 21% = $840,000
Deferred tax liability on equipment, reversing over five years: $1,000,000 x 21% = $210,000
Deferred tax liability on an indefinite-lived intangible: $1,500,000 x 21% = $315,000

Management concludes that projected income cannot be weighed heavily against the cumulative losses, and has no qualifying tax-planning strategy. Source 1 is the only reliable source.

Reversals produce $2,500,000 of future taxable income (1,000,000 + 1,500,000). Because the loss is indefinite-lived, both reversals fall within its carryforward period, but the loss can offset only 80 percent of taxable income:

Loss usable: 2,500,000 x 80% = $2,000,000
Deferred tax asset supported: 2,000,000 x 21% = $420,000
Valuation allowance: 840,000 - 420,000 = $420,000

Net deferred position: 840,000 - 420,000 - 210,000 - 315,000 = net deferred tax liability of $105,000.

Without the 80 percent limit, the reversals would support $525,000 and the allowance would be $315,000, so the limit is worth $105,000 of tax expense.

Self-check

Answer each question before you open the answer.

What threshold triggers a valuation allowance?
Show answer
A likelihood of more than 50 percent that some portion or all of the deferred tax asset will not be realized, based on the weight of available evidence (Statement 109 paragraph 17(e)).
Why does a management forecast of profits rarely overcome cumulative losses in recent years?
Show answer
Paragraph 25 weights evidence by how objectively it can be verified. Cumulative losses are historical and verifiable. A forecast is subjective, so the more negative evidence exists, the more objective positive evidence is needed.
Name the four sources of taxable income.
Show answer
Future reversals of existing taxable temporary differences, future taxable income excluding reversals and carryforwards, taxable income in carryback years if permitted, and tax-planning strategies.
In the second quarter, a company releases a valuation allowance that existed at the start of the year because of a change in judgment about future years. How is it recorded?
Show answer
As a discrete item in the second quarter, in income from continuing operations. ASC 740-270-30-11 excludes changes in judgment about beginning-of-year allowances from the estimated annual effective tax rate.

Sources

Back to the syllabus

Standards are paraphrased from the primary sources listed above; read the source before relying on a requirement. This lesson is training material, not professional advice. Report an error