At a Glance
Main Takeaway
Deferred tax assets are non-current assets on a company’s balance sheet that reduce taxable income in the future. Deferred tax liabilities are the opposite, a liability that increases taxable income in the future. Valuation allowances can offset a company’s deferred tax asset account. Accounting Standards Codification (ASC) 740 addresses how companies must recognize the effects of income taxes on their financial statements under U.S. Generally Accepted Accounting Principles (GAAP).
Next Step
Valuation allowances under ASC 740 require an in-depth understanding of both tax and book accounting regarding permanent and temporary differences to ensure compliance. Learn how to use valuation allowances for deferred tax assets and how Windes can help you calculate your allowances under U.S. tax laws and GAAP.
What is a Deferred Tax Asset Valuation Allowance?
A valuation allowance is a way to offset a deferred tax asset or liability. To determine the valuation allowance, a company should evaluate the events or assumptions that cause changes to the deferred tax.
Valuation allowances adjust the deferred tax position based on the threshold “more likely than not.” Meaning that the likelihood of an event happening is greater than 50%. If so, the allowance directly affects a company’s income statement through a deferred tax expense or benefit. The effect happens discreetly in the period the company performs the valuation and when the event occurs.
Tax assets must be evaluated to determine the necessity of a valuation allowance. Tax assets to consider include:
- Deferred tax assets that result from cumulative book and tax temporary differences
- Tax attributes with finite carryforward periods like tax credit carryforwards and net operating loss carryforwards.
When is a Deferred Tax Asset Valuation Allowance Required?
According to ASC 740-10-30-18, the future realization of a deductible temporary difference for benefit will depend on whether the company has adequate positive net income under the current year’s tax law. The income must be generated within the carryforward/carryback period from appropriate or related sources, such as capital gains on business combinations or ordinary income.
The available sources of book and tax differences include:
- Different strategies for tax planning that can be implemented, if necessary
- Taxable income in prior carryback years if the tax law permits loss carrybacks
- Future taxable income omitting temporary difference reversals and carryforwards
- Future reversals of existing temporary differences
Tax Planning Strategies for Deferred Tax Asset Valuation Allowances
A company can use specific tax planning strategies to determine if valuation allowances are necessary, such as:
- Processes that change the estimated timing and pattern of future reversals of temporary differences
- Different elections or new elections for tax purposes
To plan for deferred tax asset valuation allowances, a company must understand specific instructions on allowed tax strategies. ASC 740-10-55-39 states that qualifying tax planning strategies are as follows:
- Prudent and feasible. Management must have the ability to implement the strategy and expect to do so unless the need is eliminated in future years. For example, management would not have to apply the strategy if income earned in a later year uses the entire carryforward amount from the current year.
- Typically not taken by the company, but would be taken, in this instance, to prevent an operating loss or an unused tax credit carryforward from expiring. All of the various strategies that are expected to be employed for business or tax purposes, other than utilization of carryforwards that would otherwise expire unused, are, for purposes of this Subtopic, implicit in management’s estimate of future taxable income and, therefore, are not tax planning strategies.
- Result in the realization of deferred tax assets. The effect of qualifying tax planning strategies should be considered when determining the amount of a valuation allowance.
Scheduling Temporary Differences
When assessing valuation allowance needs, companies unable to predict future income must schedule a reversal of temporary differences to determine if any deferred tax liabilities are anticipated to balance the deferred tax assets.
Companies should employ a logical and systematic review process to schedule necessary reversals. When additional sources of taxable income become available, they must record valuation allowances against the amount of residual deferred tax not offset by the deferred tax position during the scheduling exercise.
Valuation allowances are recorded only against deferred tax assets and not deferred tax liabilities. Because deferred tax liabilities reverse and enable a company to use all deferred tax assets, no valuation allowance can be recorded. Therefore, it is standard practice for any company that finds valuation allowances necessary to make the allowance equal to or less than the amount of the deferred tax assets exceeding any deferred tax liabilities.
Accounting for Valuation Allowances Under ASC 740
If a company determines that a valuation allowance is necessary, the existing deferred tax liabilities related to the indefinite-lived intangible assets will result in a situation where the valuation allowance recognized will either exceed the net amount of any net deferred tax asset or will require the recognition of a valuation allowance for a company in a net deferred tax liability position.
Considerations for Valuation Allowance Analysis
All relevant evidence, negative and positive, must be considered when reassessing the valuation allowance. Examples of positive evidence, as stated by the ASC 740-10-30-22, that might support the determination that a valuation allowance is not needed when there is negative evidence include, but are not limited to, the following:
- Strong earnings history, without the loss that created the future deductible amount, and the evidence indicating the loss is abnormal and not a standard condition for the business.
- Surplus of appreciated assets valued over the company’s net book assets enough for the deferred tax asset to be realized.
- Firm sales backlog or existing contracts that will create more than enough taxable income to realize the deferred tax asset.
Deciding if a valuation allowance is unnecessary can be difficult when negative evidence like cumulative losses is known. Negative evidence may include:
- A brief carryforward period, limiting tax realization benefits if a sizable deductible temporary difference is expected to reverse
- Situations that could continue to affect profits and future operations negatively
- Expected losses in a currently profitable entity for future early years
- History of expired and unused tax credit carryforwards or operating losses
When to Release a Valuation Allowance
Companies must consider the timing when releasing a valuation allowance, focusing on the period when evidence becomes known concerning the reversal of the valuation allowance.
Valuation allowances should be reversed when the positive evidence eclipses the negative evidence or evidence becomes readily available to support the valuation allowance reversal. The reversal of any valuation allowance will be recorded as a deferred income tax benefit on the income statement.
Explore Valuation Allowances for Deferred Tax Assets with Windes
Failure to comply with ASC 740 guidelines for valuation allowances on deferred tax assets may damage your company’s reputation by creating a material difference in your financial statements.
Our tax professionals have specialized technical knowledge regarding ASC 740 guidelines to help you determine if your company needs a valuation allowance for deferred tax assets or updates to your valuation process. Our ASC 740 accounting services can help your business implement the appropriate practices and remain compliant with US GAAP ASC 740 Income Taxes.
Let our team of experts help you navigate this complicated but critical process. Connect with us today.