A valuation allowance is a contra balance that reduces a deferred tax asset to the amount the entity expects it will actually be able to use. It is recognized if, 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 (FASB Statement No. 109, paragraph 17). What the underlying asset is, and how it is measured before the allowance touches it, are in deferred tax assets.
Nothing about the allowance disputes that the deduction exists. It answers a different question: whether there will be enough taxable income of the right character, in the right period, to use it.
The Four Sources of Taxable Income
Realization depends on there being sufficient taxable income of the appropriate character, ordinary or capital, within the carryback and carryforward period available under the tax law, and the standard names four possible sources of it: future reversals of existing taxable temporary differences, future taxable income exclusive of reversing temporary differences and carryforwards, taxable income in prior carryback years where carryback is permitted, and tax-planning strategies (FASB Statement No. 109, paragraph 21).
Two rules about that list are easy to get backwards, and the standard states both. Where evidence about one or more sources is sufficient to support a conclusion that no allowance is necessary, the other sources need not be considered. But consideration of each source is required to determine the amount of the allowance where one is recognized (FASB Statement No. 109, paragraph 21). So a shortcut is available for the yes answer and not for the number.
Tax-Planning Strategies Have a Definition and a Cost
The fourth source is narrower than it sounds. Tax-planning strategies are actions, including elections for tax purposes, that are prudent and feasible, that an enterprise ordinarily might not take but would take to prevent an operating loss or tax credit carryforward from expiring unused, and that would result in realization of deferred tax assets (FASB Statement No. 109, paragraph 22). A plan the business would have carried out anyway is not one of these, and neither is a plan it could not actually execute.
The strategy also has to pay its own way. Significant expenses to implement a tax-planning strategy, and any significant losses that would be recognized if it were implemented, net of recognizable tax benefits on those expenses or losses, are included in the valuation allowance (FASB Statement No. 109, paragraph 22). Relying on a strategy therefore reduces the allowance by less than the deferred tax asset it saves.
The Evidence the Standard Actually Names
The guidance does not leave evidence to instinct. It lists examples on both sides, and reading them is the fastest way to see what a file needs to contain.
Forming a conclusion that no allowance is needed is difficult when there is negative evidence such as cumulative losses in recent years, and other examples of negative evidence include a history of operating loss or tax credit carryforwards expiring unused, losses expected in early future years by a presently profitable entity, unsettled circumstances that would adversely affect future operations and profit levels on a continuing basis if unfavorably resolved, and a carryback or carryforward period so brief that it would limit realization where a significant deductible temporary difference is expected to reverse in a single year or the enterprise operates in a traditionally cyclical business (FASB Statement No. 109, paragraph 23).
The positive examples are framed as examples and not prerequisites: existing contracts or a firm sales backlog that will produce more than enough taxable income at existing prices and cost structures, an excess of appreciated asset value over the tax basis of the entity’s net assets in an amount sufficient to realize the asset, and a strong earnings history exclusive of the loss that created the future deductible amount, coupled with evidence that the loss was an aberration rather than a continuing condition (FASB Statement No. 109, paragraph 24).
What decides between them is verifiability rather than volume. Judgment must be used in weighing the two, the weight given should be commensurate with the extent to which the evidence can be objectively verified, and the more negative evidence there is, the more positive evidence is necessary and the harder it becomes to support a conclusion that no allowance is needed (FASB Statement No. 109, paragraph 25). How that ranking plays out in a live provision, and how practitioners read the phrase recent years, is worked through in the income tax provision.
Where a Change in the Allowance Lands
This is the part that moves reported earnings, and it moves them in the year the judgment changes rather than the year the income arrives.
The effect of a change in the beginning-of-year balance of a valuation allowance that results from a change in circumstances causing a change in judgment about realizability in future years ordinarily is included in income from continuing operations (FASB Statement No. 109, paragraph 26).
Read that in both directions. Establishing an allowance is a charge against continuing operations, which is why a company crossing into a cumulative loss position can report a large tax expense in a year it made no more tax payments than usual. Releasing one is a credit to the same line, which is why a company returning to sustained profitability can report an unusually low or negative effective rate. Neither movement is a cash event.
Where a Firm Meets It
Inside the provision, as the conclusion rather than as a schedule. The deferred tax asset itself is computed mechanically from temporary differences and the enacted rate, which is the work described in accounting for income taxes. The allowance is the judgment sitting on top of that, and it is documented rather than calculated.
Three habits make that documentation hold. Record each of the four sources explicitly, including the ones ruled out, because the standard requires consideration of each to fix the amount. Rank the evidence by whether it can be objectively verified rather than by how convincing it reads. And where a tax-planning strategy is relied on, cost it, because its expenses go back into the allowance rather than sitting outside the calculation.
Common Questions
Because a deduction is only worth something if there is income to use it against. The asset is recognized for the future tax saving, and the allowance reduces it where, on the weight of available evidence, it is more likely than not that some or all of that saving will not be realized (FASB Statement No. 109, paragraph 17).
No. It is a reduction of an asset, so it sits against the deferred tax asset rather than in the liability block, and it never becomes an amount owed to anybody. Releasing it does not settle anything; it restores an asset that had been written down.
Accountably places trained offshore accountants and tax preparers inside US CPA and EA firms, and a firm can put a block of its own provision and workpaper preparation through a trial task so its reviewers stay on the judgment calls.
