Under the guidance of ASC 740, reporting entities are not required to provide for deferred taxes on outside basis differences in domestic subsidiaries based on an assertion that they have the ability and intent to recover the amount of their investment in a tax-free manner. In advance of a bankruptcy filing, it may be difficult to continue to support this assertion if, for instance, a disposal of the subsidiary may be required to fund cash flow needs.

Reporting entities should consider the need for valuation allowances against deferred tax assets in advance of a bankruptcy filing. Given the nature of events that typically precede a bankruptcy filing, including ongoing operating losses, deteriorating credit conditions, etc., it may be more likely than not that the tax benefits from deferred tax assets will not be realized and that a valuation allowance should be recorded. Careful consideration should be given to the reporting entity's history of operating losses and the impact that a bankruptcy filing could have on the reporting entity's ability to utilize deferred tax assets in the future. The assumptions, such as earnings projections, used in assessing the realizability of deferred tax assets should be consistent with assumptions used in impairment testing and consideration of the reporting entity's ability to continue as a going concern. This assessment will often lead to a conclusion that a valuation allowance is required prior to a bankruptcy filing.

The impact on net income from certain changes may be amplified when a full valuation allowance is recorded. For example, charges for items such as long-lived asset impairments that typically give rise to a deferred tax asset will not be reduced by a tax benefit when a reporting entity has recorded a full valuation allowance. For further discussion on valuation allowance assessments see TX 5.