When a valuation allowance on deferred tax assets is required under ASC 740 and IAS 12

A deferred tax asset is a claim on future tax savings: deductible temporary differences, tax loss carryforwards and tax credit carryforwards reduce the tax an entity will pay later, but only if the entity later has taxable income against which to use them. ASC 740 deals with that uncertainty through a valuation allowance, a contra account that reduces the deferred tax asset to the amount that is more likely than not to be realized. IAS 12 reaches a similar economic answer by a different route, recognizing a deferred tax asset only to the extent that it is probable that taxable profit will be available.

The question becomes acute when an entity moves into losses. A company that has reported profits for years can carry a full deferred tax asset without much debate, but two or three loss-making years change the evidence. Auditors, audit committees and regulators then expect a documented assessment of whether the asset can still be supported, and the answer can move the effective tax rate by many percentage points in a single period.

The same assessment works in reverse when a loss-making company returns to profit. Releasing a valuation allowance, or recognizing a previously unrecognized asset under IFRS, produces a deferred tax benefit that can exceed the pre-tax profit of the year, so the timing of the release is one of the most closely examined judgements in tax accounting.

··········

WHEN A VALUATION ALLOWANCE ASSESSMENT IS NEEDED.

Under ASC 740 the assessment is not limited to companies in trouble. Every deferred tax asset is measured in full first, using the enacted tax rate expected to apply, and then tested for realizability. The gross asset stays on the books and the valuation allowance is recorded against it whenever the evidence indicates that some portion will not be realized.

In practice, the assessment becomes substantive in a few recurring situations: a history of recent losses, either at the entity level or in a specific tax jurisdiction; tax loss or credit carryforwards approaching expiry; a restructuring, a loss of a major customer or a change in the business model that weakens forecasts; acquisitions that bring in carryforwards subject to legal limitations; and deferred tax assets of a character, such as capital losses, that can only be used against income of the same character.

The assessment is performed by jurisdiction and, where the tax law separates income types, by character of income. A group that is profitable on a consolidated basis can still need a valuation allowance in a subsidiary or a country where it has persistent losses, because profits in one tax jurisdiction usually cannot absorb losses in another. The general recognition model for deferred taxes is covered in how deferred tax assets and liabilities are recognized under IAS 12 and ASC 740; the focus here is the realizability test that sits on top of it.

··········

THE VALUATION ALLOWANCE TEST UNDER ASC 740.

The requirement originated in FASB Statement No. 109 Accounting for Income Taxes and is now part of ASC 740. A deferred tax asset is reduced by a valuation allowance if, based on the weight of available evidence, it is more likely than not that some portion or all of the asset will not be realized. The standard defines more likely than not as a likelihood of more than 50 percent.

Realization depends on the existence of sufficient taxable income of the appropriate character within the carryback and carryforward periods available under the tax law. ASC 740 identifies four possible sources of that taxable income:

1. Future reversals of existing taxable temporary differences.

2. Future taxable income exclusive of reversing temporary differences and carryforwards.

3. Taxable income in prior carryback years, if carryback is permitted under the tax law.

4. Tax-planning strategies, meaning prudent and feasible actions that management would take to prevent a carryforward from expiring unused.

The order of the list reflects how objectively each source can be verified. Reversing taxable temporary differences are the most objective, because they come from balances already in the financial statements, provided they reverse in a period and jurisdiction in which the deductible items can be used. Carrybacks are also relatively objective where the tax law allows them. Projections of future taxable income are the most subjective source and carry the least weight when the entity has a recent history of losses.

All available evidence, positive and negative, must be considered. The standard gives examples of negative evidence: cumulative losses in recent years, a history of operating loss or tax credit carryforwards expiring unused, losses expected in early future years by a presently profitable entity, and unsettled circumstances that would adversely affect future operations if resolved unfavorably. Examples of positive evidence include existing contracts or a firm sales backlog that will produce enough taxable income, an excess of appreciated asset value over the tax basis of the entity's net assets, and a strong earnings history exclusive of the loss that created the deductible amount, where that loss came from an aberration rather than a continuing condition.

The weight given to each piece of evidence must be commensurate with the extent to which it can be objectively verified. Cumulative losses in recent years are a significant piece of objectively verifiable negative evidence, and forecasts of a turnaround are difficult to set against them. Many companies and auditors look at a three-year cumulative pre-tax result, adjusted for permanent items, as a starting point, although ASC 740 does not set a bright-line period and the conclusion always rests on the full body of evidence.

When judgement about the realizability of the beginning-of-year asset changes, the effect is ordinarily included in income from continuing operations. In interim reporting, the effect of a changed judgement about beginning-of-year valuation allowances is kept out of the estimated annual effective tax rate (ASC 740-270-30-11) and is recognized in the interim period in which the judgement changes, while an allowance that relates to deferred tax assets arising in the current year flows through the estimated annual rate.

··········

HOW IAS 12 LIMITS DEFERRED TAX ASSET RECOGNITION.

IAS 12 Income Taxes has no valuation allowance account. Paragraph 24 requires a deferred tax asset for all deductible temporary differences to the extent that it is probable that taxable profit will be available against which the deductible temporary difference can be utilized, unless an initial recognition exception applies. Paragraph 27 repeats that an entity recognizes deferred tax assets only when it is probable that it will have taxable profits against which to use the deductions, and paragraph 28 treats taxable profit as probable when there are sufficient taxable temporary differences relating to the same taxation authority and the same taxable entity that are expected to reverse in the appropriate periods.

When reversing taxable temporary differences are insufficient, IAS 12 allows recognition to the extent that the entity will probably have sufficient taxable profit of its own in the relevant periods, or that tax planning opportunities are available to create taxable profit. Paragraph 27A adds that where tax law restricts the use of losses to income of a specific type, the assessment is made only in combination with deductible temporary differences of that type.

For unused tax losses and unused tax credits, IAS 12 applies the same probability test and adds a direct warning: the existence of unused tax losses is strong evidence that future taxable profit may not be available. An entity with a history of recent losses therefore recognizes a deferred tax asset arising from those losses only to the extent that it has sufficient taxable temporary differences or convincing other evidence that sufficient taxable profit will be available. The standard also asks whether the losses come from identifiable causes that are unlikely to recur.

Two further requirements complete the model. At each reporting date the entity reassesses unrecognized deferred tax assets and recognizes them to the extent that future taxable profit has become probable. The carrying amount of recognized deferred tax assets is also reviewed at each reporting date and reduced to the extent that sufficient taxable profit is no longer probable, with the reduction reversed if probability returns. IAS 12 does not define probable within the standard, so entities apply the term with judgement and explain the basis in their disclosures.

··········

VALUATION ALLOWANCE VS IAS 12 RECOGNITION: COMPARISON.

The two frameworks often produce the same net deferred tax asset, but they record it differently and use different words for the threshold.

........

Issue	ASC 740	IAS 12
Mechanism	Gross asset less valuation allowance	Asset recognized only to the probable extent
Threshold	More likely than not (above 50%)	Probable taxable profit
Sources of income	Four sources listed	Reversing differences, future profits, tax planning
Recent losses	Significant negative evidence	Strong evidence profit may not be available
Reassessment	Every reporting date	Every reporting date
Main disclosure	Allowance and its net change	Unrecognized amounts and supporting evidence

........

In practice, the vocabulary difference has limited effect when an entity has clear evidence either way. The differences appear in borderline cases, in the bookkeeping (a separate contra account under US GAAP versus a single net asset under IFRS) and in the disclosures, because a US GAAP preparer shows the gross asset and the allowance, while an IFRS preparer discloses the deductible temporary differences and losses for which no asset was recognized.

··········

VALUATION ALLOWANCE WORKED EXAMPLE WITH JOURNAL ENTRIES.

The figures below are illustrative. The entity operates in a single tax jurisdiction with an enacted rate of 25 percent, and the tax law in this example lets tax losses be carried forward indefinitely with no annual cap and no carryback. At the end of Year 1 it has reported pre-tax losses in each of the last three years. Management's forecasts show a return to profit in Year 3, but the forecasts are not objectively verifiable and the board has not approved a restructuring that would change the cost base.

Deferred tax balances at the end of Year 1, before any valuation allowance:

........

Item	Temporary difference or loss	Deferred tax at 25%
Tax loss carryforward	4,000,000	1,000,000 asset
Warranty provision	600,000	150,000 asset
Gross deferred tax assets	4,600,000	1,150,000
Accelerated tax depreciation	1,800,000	450,000 liability

........

The only objectively verifiable source of taxable income is the reversal of the 1,800,000 taxable temporary difference on property, plant and equipment, which is expected to reverse over the same years in which the losses and warranty deductions can be used. That reversal supports 450,000 of the deferred tax assets. The remaining 700,000 (1,150,000 less 450,000) is not supported, because the cumulative losses outweigh the unverified forecasts.

Under US GAAP the entity keeps the gross asset of 1,150,000 and records a valuation allowance of 700,000. Under IFRS it recognizes a deferred tax asset of 450,000 and does not recognize the remaining 700,000. Assuming the asset was carried in full at the start of Year 1, the entries are:

........

Framework	Account	Debit	Credit
US GAAP	Deferred tax expense	700,000
US GAAP	Valuation allowance (contra deferred tax asset)		700,000
IFRS	Deferred tax expense	700,000
IFRS	Deferred tax asset		700,000

........

The net deferred tax position is nil under both frameworks: deferred tax assets of 450,000, net of the allowance under US GAAP, against a deferred tax liability of 450,000. The IFRS notes disclose unrecognized deductible temporary differences and unused tax losses of 2,800,000 (4,000,000 plus 600,000 less the 1,800,000 covered by reversing taxable differences), with a tax effect of 700,000.

By the end of Year 3 the entity has two consecutive profitable years, a signed multi-year supply contract and budgets that have been met. Part of the loss has been used. The balances before reassessment are a tax loss carryforward of 2,400,000 (deferred tax 600,000), a warranty provision of 520,000 (deferred tax 130,000) and a taxable temporary difference of 1,400,000 (deferred tax liability 350,000). Gross deferred tax assets are 730,000, and the allowance carried on the old basis would be 380,000 (730,000 less 350,000).

Management concludes that the positive evidence now outweighs the negative evidence and that the full asset is more likely than not to be realized. The entries are:

........

Framework	Account	Debit	Credit
US GAAP	Valuation allowance (contra deferred tax asset)	380,000
US GAAP	Deferred tax benefit		380,000
IFRS	Deferred tax asset	380,000
IFRS	Deferred tax income		380,000

........

After the release, the net deferred tax asset is 380,000 under both frameworks (730,000 of assets less 350,000 of liability). Because the change in judgement relates to the beginning-of-year balances, a US GAAP preparer recognizes the benefit in continuing operations in the interim period in which the judgement changes, which is why a large one-off reduction in the effective tax rate often appears in a single quarter. If part of the release related to losses expected to be used against current-year income, that part would flow through the estimated annual effective tax rate instead.

··········

PRESENTATION AND DISCLOSURE OF UNRECOGNIZED DEFERRED TAX ASSETS.

Under US GAAP the balance sheet shows deferred tax assets net of the valuation allowance, offset against deferred tax liabilities of the same tax-paying component and jurisdiction, and classified as noncurrent. The notes show the total of deferred tax assets, the total valuation allowance and the net change in the allowance during the year, together with the amounts and expiry dates of operating loss and tax credit carryforwards. Public companies also explain the main reasons for unusual movements in the effective rate, and a valuation allowance release or charge is usually one of them.

Under IFRS the notes disclose the amount, and expiry date if any, of deductible temporary differences, unused tax losses and unused tax credits for which no deferred tax asset is recognized. When an entity recognizes a deferred tax asset whose use depends on future taxable profits beyond the reversal of existing taxable temporary differences, and it has suffered a loss in the current or preceding period in the same jurisdiction, it discloses the amount of the asset and the nature of the evidence supporting its recognition. Regulators review that evidence closely in loss-making entities, and the disclosure should match the forecasts used for impairment testing and the going concern assessment, a point discussed in how the going concern assessment and disclosures work under IAS 1 and ASC 205-40.

··········

COMMON ERRORS IN VALUATION ALLOWANCE ASSESSMENTS.

The most frequent error is counting taxable temporary differences that do not reverse in time or in the right jurisdiction. A deferred tax liability on an asset that is not depreciated or amortized for book purposes, such as land or tax-deductible goodwill, may not reverse within the carryforward period and then cannot support a deferred tax asset that will expire. Where the tax law caps how much of each year's taxable income can be offset by losses, scheduling is needed to show how much of the reversal can absorb the carryforward.

A second error is relying on forecasts that are inconsistent with other parts of the financial statements. If the impairment test, the going concern assessment and the tax forecasts use different assumptions, the weakest set will usually be challenged. A third error is releasing an allowance too early on the strength of one profitable quarter, or too late after the evidence has clearly changed, which shifts tax benefits between periods.

Tax-planning strategies are also misused. A strategy must be prudent and feasible, within management's control and something the entity would actually do to avoid losing the carryforward; costs of implementing it reduce the benefit. A plan that requires selling a core business or that the board would not approve does not qualify. Finally, uncertain tax positions interact with the assessment: a carryforward reduced by an unrecognized tax benefit is smaller than the one in the tax return, a topic covered in corporate tax reporting under ASC 740 and uncertain tax positions.

··········

VALUATION ALLOWANCE CHECKLIST FOR YEAR-END.

Before signing off the deferred tax note, the tax and financial reporting teams can work through a short list. Measure all deferred tax assets gross at the enacted rate, by jurisdiction and by character of income. Compute the cumulative pre-tax result for recent years, adjusted for permanent differences and non-recurring items, and document why the period chosen is relevant. Schedule the reversal of taxable temporary differences against the use of deductible items and carryforwards, including expiry dates and any annual limitation imposed by the tax law.

Then list the positive and negative evidence and assign weight according to how objectively each item can be verified. Test any tax-planning strategy for feasibility and cost. Reconcile the forecasts with those used for impairment and going concern. Record the conclusion, the movement in the allowance or in unrecognized amounts, and the interim treatment of any change, and draft the disclosures that explain the judgement. A broader view of how these balances feed the tax charge is in how income taxes are accounted for under IAS 12 and ASC 740.

··········

DEFERRED TAX ASSET REALIZABILITY UNDER ASC 740 AND IAS 12: CONCLUSIONS.

Both frameworks require evidence that taxable income will be available before a deferred tax asset can count fully on the balance sheet. ASC 740 applies a more likely than not threshold, defined as more than 50 percent, and records the shortfall as a valuation allowance against a gross asset. IAS 12 recognizes the asset only to the extent that taxable profit is probable and discloses what remains unrecognized. In the illustrative case above, both approaches leave the same net position in each year and differ only in how the balances and notes are laid out.

The judgement lies in the evidence. Cumulative recent losses weigh heavily under both standards, reversing taxable temporary differences are the most reliable support, and forecasts carry weight only when they can be verified. Neither standard sets a fixed look-back period or a numeric definition of probable for IFRS purposes, so the outcome depends on the entity's facts, the tax law of each jurisdiction and the consistency of its forecasts across the financial statements.

··········

FOLLOW US FOR MORE.

·····

DATA STUDIOS

·····

datastudios.org