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A valuation allowance assessment is both subjective and mechanical. Multiple factors enter into the assessment that make it highly subjective, including:
  • assessing whether the weight of available evidence supports the recognition of some or all of an entity’s deferred tax assets;
  • determining how objectively verifiable an individual piece of evidence is, and thus how much weight should be given to the evidence; and
  • establishing the reversal patterns for existing temporary differences.
However, once those determinations have been made, the process of computing the valuation allowance necessary is mechanical. This mechanical process is important and will have an impact when the weight of available evidence suggests that income in applicable future periods will be insufficient to support the realization of all deferred tax assets. In circumstances when a partial valuation allowance is warranted, the valuation allowance required generally must be supported through detailed scheduling of reversals of temporary differences.
Some have used formulas as a starting point to determine the valuation allowance. These can be good techniques to organize the thought process for evaluating the need for a valuation allowance, but they are not a substitute for reasoned judgment. The valuation allowance recorded should be based on management’s judgment of what is more-likely-than-not considering all available information, both quantitative and qualitative. An approach in which a valuation allowance is determined by reference to a certain percentage of an entity’s deferred tax assets would not be appropriate.
Ultimately, the realization of deferred tax assets will depend on the existence of future taxable income, sources of which are covered in TX 5.3.
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