Valuation Allowance

A valuation allowance is the contra-asset recorded against deferred tax assets when it is not more likely than not - meaning a likelihood of 50 percent or less - that some or all of those assets will be realized. ASC 740 requires deferred tax assets to be recognized in full initially, then reduced by a valuation allowance to the amount expected to be realized. The allowance is not a write-off; it is a reserve that can be released when circumstances improve.

The assessment weighs all available evidence, positive and negative, with more weight given to objectively verifiable evidence than to projections. Four sources of taxable income are considered: future reversals of existing taxable temporary differences, projected future taxable income exclusive of reversing differences, taxable income in carryback years where permitted, and available tax planning strategies that are prudent and feasible.

Cumulative losses in recent years - typically evaluated as a three-year cumulative pre-tax result adjusted for unusual items - constitute significant negative evidence that is, in the standard's framing, difficult to overcome. When a company is in a cumulative loss position, reliance on forecasts of future profitability generally will not support recognition, and a full valuation allowance is often the outcome.

Practically, valuation allowance decisions move the effective tax rate dramatically and attract close auditor and regulator attention. Establishing an allowance can push a modestly unprofitable company to a large net loss; releasing one can produce an enormous one-time benefit. CPA firms are frequently engaged to build the supporting analysis, document the evidence weighting, and defend the conclusion through audit and, later, through diligence.