7.2 Valuation Allowances and Tax Rate Changes

Valuation Allowances for Deferred Tax Assets

Deferred Tax Assets and Their Realization

A deferred tax asset (DTA) represents a future tax benefit a company expects to receive. These typically arise from temporary differences between book and taxable income, or from carryforwards of net operating losses and tax credits.

Before reporting a DTA at full value, a company must assess whether it will actually be able to use that benefit. This assessment relies on weighing positive evidence against negative evidence:

• Positive evidence supports realization of the DTA:
  • Strong recent earnings history
  • Projected future profitability
  • Existing deferred tax liabilities that will reverse in the same period (generating taxable income to absorb the DTA)
• Negative evidence suggests the DTA may not be fully realizable:
  • Cumulative losses over recent years (typically a three-year lookback)
  • Expected future losses
  • Insufficient projected taxable income to use the benefits before they expire

The standard under ASC 740 treats cumulative losses as a particularly strong piece of negative evidence that's difficult to overcome with projections alone.

Valuation Allowance and Its Assessment

A valuation allowance (VA) is a contra-asset account that reduces the carrying value of a DTA. You record one when it is more likely than not (greater than 50% likelihood) that some or all of the DTA will not be realized.

Think of it this way: the DTA stays on the books at its gross amount, but the VA offsets it so the net DTA reflects only the portion the company actually expects to use.

Situations that commonly require a valuation allowance:

• A company with a history of operating losses expects continued losses, making it unlikely to generate enough taxable income to absorb its DTAs
• A company holds tax credit carryforwards expiring in the near future and does not project sufficient taxable income to use those credits before expiration

Tax Rate Changes on Deferred Taxes

Impact of Tax Rate Changes

Deferred tax assets and liabilities are measured using the enacted tax rates expected to apply when the underlying temporary differences reverse. When a new rate is enacted, all existing deferred tax balances must be remeasured.

Here's how the direction of the rate change affects the balances:

• Tax rate increases: Both DTAs and DTLs increase in value. The net effect on income tax expense depends on whether the company carries a larger DTA or DTL balance.
• Tax rate decreases: Both DTAs and DTLs decrease in value. Again, the net income statement effect depends on the relative size of each balance.

Recognition of Tax Rate Changes

The effect of a rate change on deferred tax balances is recognized as a discrete item in income tax expense or benefit in the period that includes the enactment date of the new rate. The key date is enactment, not the effective date when the rate actually applies.

Companies must also reassess their valuation allowances in light of the new rate. For example, if a rate decrease shrinks a DTA to the point where realization becomes doubtful, an additional VA may be needed in that same period.

Accounting for Valuation Allowances and Tax Rate Changes

Recording Changes in Valuation Allowances

Changes in the VA hit the income statement in the period the change occurs:

• Increase in VA → additional income tax expense (reduces net DTA, signals less expected future benefit)
• Decrease in VA → income tax benefit (increases net DTA, signals improved expectations for realization)

When a VA change is triggered by a tax rate change, that effect is also recognized as a discrete item in income tax expense or benefit for the period.

Recording Changes in Tax Rates

The remeasurement process works in clear steps:

1. Identify all deferred tax assets and liabilities on the balance sheet as of the enactment date
2. Recalculate each balance using the newly enacted rate
3. Record the difference between the old and new carrying amounts as a discrete component of income tax expense or benefit
4. Reassess the valuation allowance under the new rate and record any needed adjustment

Companies must disclose the significant components of income tax expense in the notes to the financial statements, including the effects of VA changes and rate changes separately.

Financial Statement Impacts

Income Statement Effects

Changes in valuation allowances and tax rates flow through the income tax expense (or benefit) line, directly affecting net income and earnings per share.

• An increase in the VA or a rate change that produces net deferred tax expense → higher total tax expense → lower net income
• A decrease in the VA or a rate change that produces net deferred tax benefit → lower total tax expense → higher net income

For example, if a company records a new $\$2{,}000{,}000$ valuation allowance because it now expects future losses, income tax expense increases by that amount in the current period, reducing net income dollar-for-dollar (before considering any other tax adjustments).

Balance Sheet Effects

On the balance sheet, these changes affect the carrying values of deferred tax accounts:

• Valuation allowance changes adjust the net DTA. An increase in the VA reduces the net DTA reported; a decrease raises it.
• Tax rate changes affect both DTAs and DTLs. A rate increase raises both balances; a rate decrease lowers both.

Analysts pay close attention to large swings in valuation allowances because they signal management's changing expectations about future profitability. A company that suddenly releases a large VA is telling the market it now expects to be profitable enough to use those tax benefits. Conversely, establishing a large new VA can indicate deteriorating earnings expectations or upcoming expirations of carryforwards.