Valuation Allowance For Deferred Tax Assets: A Quick Guide

In the wake of the COVID-19 pandemic, valuation allowances for deferred tax assets are likely to become an issue for many businesses. Shutdowns and general disruption of business operations have had a negative financial impact on many businesses and are likely to result in significant numbers of businesses realizing a cumulative loss for 2020 (and perhaps for 2021 as well).

This is likely to have an impact on businesses that went into 2020 with deferred tax assets on the books (and potentially many that did not but still suffered severe revenue impacts from the pandemic). Undoubtedly, in some cases, this will necessitate a valuation allowance to reduce the deferred tax assets, given the unknowns about the post-pandemic recovery.

In this article, we’ll define what deferred tax assets and valuation allowances are—and when it is appropriate to apply a valuation allowance.

What is a deferred tax asset?

In simplest terms, a deferred tax asset (DTA) arises from overpayment or advance payment of taxes. It can result from a difference between tax and accounting rules or a carryover of tax losses. On the balance sheet, DTAs are listed as assets, since they represent a past expense that can potentially be recouped in the future. Deferred tax assets can be “redeemed” in a future period of profitability to reduce tax obligations—the tax paid will be reduced by the value of the DTAs, which were essentially a pre-payment of the current tax obligation. Thus, DTAs have the net effect of increasing revenue when they are redeemed.

Prior to the Tax Cut and Jobs Act of 2017 (TCJA), there was a limited time window in which DTAs could be carried forward to defray a current tax obligation. The TCJA eliminated the time limit, meaning that DTAs now have an unlimited lifespan—at least in theory. In practice, it’s extremely unlikely that a DTA dating from 2018, just after passage of the TCJA, would still be on the books to redeem in 2028—not only because tax policy may change in the interim but also for the reasons noted in the following sections.

Need help determining if a valuation allowance for your deferred tax assets is required? Schedule a free discovery call with Valentiam’s valuation experts.

What is a valuation allowance for deferred tax assets?

Deferred tax asset valuation allowances come into play when it’s unlikely that the business will be able to recoup the full value of the deferred tax asset. For example, if the business has been losing money for several years, it is less likely to have profits in the current year or the near future against which to apply the deferred tax asset to reduce its tax burden.

In this situation, the firm has been losing money for several years and accumulating deferred tax assets. These deferred tax assets reside on the balance sheet as assets—and the larger the losses, the larger the deferred tax assets. This is not a problem if the company is likely to be able to use those assets in the future during periods of profitability.

But if the company is on a long-term or permanent slide into unprofitability, accumulated deferred tax assets can distort the company’s balance sheet, overstating its value. Unless the business returns to profitability, those deferred tax assets are worthless; they cannot be sold or used by another party. An adjustment needs to be made to reflect the fact that some or all of the deferred tax assets are unlikely to be recouped.

To reconcile the balance sheet and the company’s actual value, a valuation allowance for the deferred tax assets reduces the value of the assets carried on the balance sheet. Removing these “phantom” assets reduces the distortion of company value, aligning values on the balance sheet more closely with the actual value of the business.

In a business valuation, this re-alignment is necessary for compliance with Accounting Standards Codification 820 (ASC 820) of the Financial Accounting Standards Board (FASB), which defines fair market value as the price an asset would command in a transaction between participants in the open market. Clearly, a reasonable buyer would not pay for assets with no present value and no value which can be realized in the future, so an adjustment is necessary for ASC 820 compliance.

When is it appropriate to apply a valuation allowance for deferred tax assets?

Under FASB’s ASC 740, deferred tax assets must be reduced by a valuation allowance for any portion of the assets not expected to be realized. To realize the DTAs, the business must have sufficient income within the carryforward period to recoup those assets. As previously noted, that carryforward period is indefinite under the changes imposed by the TCJA. But that doesn’t mean deferred tax assets can remain on the balance sheet indefinitely when there is little chance they can be realized.

ASC 740 requires a valuation allowance when the preponderance of evidence—both positive and negative—indicates that part or all of the DTAs will not be realized. FASB guidance states that “forming a conclusion that a valuation allowance is not needed is difficult when there is negative evidence…” Examples of negative evidence include:

• Past history of tax credit carryforwards expiring unused
• Expected losses in years in the near future by a currently profitable company
• Issues or circumstances that if unfavorably resolved will adversely impact future operations and profits on a continuing basis

As such, the indefinite period for carryforward of DTAs is likely to be inoperable for most businesses. Events such as the COVID-19 pandemic may cause historical or current information to lack relevance, requiring deeper analysis and revision of future forecasts. Regardless of past business performance and profitability, the effects of the pandemic are a piece of negative evidence with just as much weight as cumulative past losses. Because any negative evidence is difficult to overcome, even businesses that were profitable prior to the pandemic may be subject to a valuation allowance. However, if it is later determined that the DTAs will be realized, the valuation allowance can be reversed.

How are deferred tax asset valuation allowances calculated?

The process for identifying deferred tax assets and determining whether a valuation allowance is required has five steps:

1. Identify basis differences between GAAP (Generally Accepted Accounting Practices) and tax balance sheets with future tax implications.
2. Categorize differences into future taxable and future deductible amounts to determine whether the difference is a deferred tax liability or a deferred tax asset.
3. Determine the correct tax rate. The rate to use is the enacted rate applicable when the difference is anticipated to reverse.
4. Calculate the deferred tax assets, using the rate from step 3.
5. Consider whether a valuation allowance is required. If it is more likely than not (a greater than 50% chance) that the assets will not be fully recoverable, ASC 740 requires a valuation allowance. The assets should be reduced to the amount that more likely than not can be recovered—meaning there is a greater than 50% chance that the remaining assets are recoverable.

Obviously, determining whether or not a valuation allowance is required—and the amount of that adjustment—requires significant judgement. Accurate forecasts of the future rely on making the right set of assumptions; if any of those assumptions are incorrect, the forecast may diverge significantly from reality in how the future unfolds.

Ultimately, ASC 740 valuation allowance guidance has the same intent as goodwill impairment testing: to bring the assets on the balance sheet into alignment with fair market value. ASC 740’s “more likely than not” standard for determining whether a valuation allowance is required is intended to offset wishful thinking that otherwise might keep deferred tax assets on the balance sheet indefinitely, creating a widening gap between the value reflected in the balance sheet and the actual fair market value of the business.

Need help determining the fair market value of your business assets?

At Valentiam, our valuation experts have decades of combined experience in providing accurate, defensible valuations and transfer pricing services. We perform appraisals and provide transfer pricing solutions to U.S. and international companies in a variety of industries—including several Fortune 100 organizations. Contact us to see how we can help your company with all its valuation and transfer pricing needs.