The valuation allowance

The valuation allowance is one of the largest judgments in US income tax accounting and a frequent subject of SEC comment letters. Releasing or recording one can swing earnings by millions. This guide explains the test, the four sources of taxable income, how evidence is weighed, and works through a loss-making company.

By Awais Jameel, Chartered Accountant. Reviewed by Muhammad Bilal, Chartered Accountant. 3 minute read.

Short answer

Under ASC 740, a valuation allowance reduces deferred tax assets to the amount that is more likely than not, a likelihood of more than 50%, to be realized. The assessment weighs all available positive and negative evidence about whether there will be sufficient taxable income of the right character in the right periods, from four sources: reversing taxable temporary differences, future taxable income, carryback, and tax planning strategies. Cumulative losses in recent years are significant negative evidence that is difficult to overcome.

At a glance

Test
More likely than not to be realized
Evidence
All positive and negative evidence
Sources
Four sources of taxable income
Cumulative losses
Significant negative evidence
Reassessed
Each reporting period
IFRS
No allowance; recognize only probable
The valuation allowanceTest: More likely than not to be realized; Evidence: All positive and negative evidence; Sources: Four sources of taxable income; Cumulative losses: Significant negative evidence; Reassessed: Each reporting period; IFRS: No allowance; recognize only probable.KEY FACTS AT A GLANCEThe valuation allowanceTestMore likely than not tobe realizedEvidenceAll positive and negativeevidenceSourcesFour sources of taxableincomeCumulative lossesSignificant negativeevidenceReassessedEach reporting periodIFRSNo allowance; recognizeonly probableTax BakersThe valuation allowanceTest: More likely than not to be realized; Evidence: All positive and negative evidence; Sources: Four sources of taxable income; Cumulative losses: Significant negative evidence; Reassessed: Each reporting period; IFRS: No allowance; recognize only probable.KEY FACTS AT A GLANCEThe valuation allowanceTestMore likely than not to be realizedEvidenceAll positive and negative evidenceSourcesFour sources of taxable incomeCumulative lossesSignificant negative evidenceReassessedEach reporting periodIFRSNo allowance; recognize only probableTax Bakers
Key facts at a glance, as set out in this guide.

How does the valuation allowance test work?

Is a valuation allowance needed?Is a valuation allowance needed?Do reversing taxable differencescover the deferred tax asset?YesNo allowancefor that partNot fullyDoes the evidence, weighted forobjectivity, support future income?YesNo allowancefor that partNoRecord a valuation allowance for the rest
Cumulative losses in recent years weigh heavily against relying on forecasts.

What are the four sources of taxable income?

  1. Future reversals of existing taxable temporary differences, such as deferred tax liabilities on depreciation that will reverse in the right periods and jurisdictions.
  2. Future taxable income excluding reversing temporary differences and carryforwards, based on forecasts.
  3. Taxable income in prior carryback years, where carryback is allowed. Federal losses arising after 2017 generally cannot be carried back.
  4. Tax planning strategies: prudent and feasible actions the company would take to prevent an attribute from expiring, such as selling appreciated assets.

How is positive and negative evidence weighed?

Negative evidencePositive evidence
Cumulative losses in recent years, commonly assessed over three yearsExisting contracts or firm sales backlog producing taxable income
History of losses or of carryforwards expiring unusedStrong earnings history excluding the loss from an unusual item
Losses expected in the near futureAppreciated assets whose sale would produce taxable income
Short carryforward periodsLong or indefinite carryforward periods

Evidence is weighted by how objectively it can be verified. A three-year cumulative loss is objective negative evidence, and forecasts of future profit are usually not enough on their own to overcome it.

A worked valuation allowance example

A company has federal net operating loss carryforwards of $500,000, a deferred tax asset of $105,000 at 21%. It also has a deferred tax liability of $30,000 on depreciation that will reverse over the next few years. It has a cumulative pretax loss over the last three years and forecasts only modest profits.

$
Deferred tax asset on loss carryforwards105,000
Supported by reversing deferred tax liabilities (allowing for the 80% limit on using post-2017 losses)(24,000)
Valuation allowance81,000
Net deferred tax asset recognized24,000

The forecast profits are not given weight because of the cumulative loss, however confident management is in its plan. When the company returns to sustained profitability, it releases the allowance, usually producing a large income tax benefit in that period.

When is a valuation allowance released?

When the weight of positive evidence becomes sufficient, typically after the company has emerged from a cumulative loss position and has a sustained record of profits, supported by forecasts that have proved reliable. The release is recognized as an income tax benefit in the period the assessment changes; part of it may be spread through the estimated annual effective tax rate in interim periods.

Are state valuation allowances different?

Each jurisdiction, and each type of attribute such as capital losses, is assessed separately. A company may need a valuation allowance for state losses in one state where it has stopped operating while needing none for federal deferred tax assets.

Common mistakes

  • Giving weight to optimistic forecasts despite a cumulative loss.
  • Counting the same reversing deferred tax liability twice, against several assets.
  • Ignoring the 80% limitation on using post-2017 federal losses.

What must be disclosed?

The total valuation allowance and the net change during the year, and the amounts and expiration dates of carryforwards. Public companies also discuss significant judgments in MD&A and critical accounting estimates.

How does IFRS compare?

IFRS has no valuation allowance; deferred tax assets are recognized only to the extent recovery is probable, which usually gives a similar net answer. See deferred tax assets under IAS 12, IAS 12 vs ASC 740 and ASC 740 deferred taxes.

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Questions people ask

What is a valuation allowance under ASC 740?

A reduction of deferred tax assets to the amount more likely than not to be realized, based on all available evidence.

What are the four sources of taxable income?

Reversals of existing taxable temporary differences, future taxable income, carryback income, and tax planning strategies.

Is a three-year cumulative loss significant?

Yes. Cumulative losses in recent years are significant negative evidence that is difficult to overcome.

What happens when a valuation allowance is released?

The deferred tax asset is recognized, usually producing an income tax benefit in the period of release.

Sources

Every fee, date and rule on this page was taken from these official and primary sources.

  1. FASB Accounting Standards Codification: Topic 740, Income Taxes
  2. Financial Accounting Standards Board

Rules and fees change. If you are reading this long after October 4, 2026, confirm the figures with the source before you rely on them.

ASC 740Deferred taxes under ASC 740ASC 740ASC 740 income taxes explainedIAS 12Recognising deferred tax assets and tax losses

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This guide is general information. It is not tax or legal advice for your situation.