CFA Level I Exam · Analysis of Income Taxes

Valuation Allowance and Tax Loss Carryforwards Explained

Updated 7 October 2026 · Fact-checked

A deferred tax asset is only worth recognizing if the firm will probably have enough future taxable profit to use it. Under US GAAP, a valuation allowance reduces the asset when it is more likely than not (over 50%) that some part will not be realized. Under IFRS, the asset is recognized only to the extent that use is probable.

Understand Valuation Allowance and Tax Loss Carryforwards

A deferred tax asset (DTA) is a tax saving you expect in future years. It arises from deductible temporary differences and from unused tax losses (tax loss carryforwards). A firm that loses money this year can often deduct that loss against profits in later years and pay less tax then.

But the saving is real only if the firm earns taxable profit later. If it never does, the DTA is worth nothing. So accounting asks one question: is it likely the asset will be used?

Under US GAAP, the firm first records the full DTA. It then deducts a valuation allowance, a contra account, if it is more likely than not (probability above 50%) that some or all of the DTA will not be realized. The balance sheet shows the DTA net of the allowance. Increasing the allowance raises income tax expense and lowers net income. Reducing it lowers tax expense and raises net income.

Under IFRS, there is no valuation allowance account. The firm recognizes a DTA only to the extent it is probable that future taxable profit will be available. The carrying amount is reviewed at each reporting date. It is written down if recovery is no longer probable, and the write-down can be reversed later.

Evidence for recoverability includes: a history of profits or losses, expected reversal of taxable temporary differences, future taxable income forecasts, and tax planning options. A history of losses is strong negative evidence. Analysts watch these changes because the allowance is a judgment, and management can use it to shift earnings between periods.

Key formulas to remember

US GAAP valuation allowance test: Allowance required if P(DTA not realized) > 50% (more likely than not); Allowance = the portion of the DTA not expected to be realized. Reported DTA = gross DTA − valuation allowance.
IFRS recognition test: Recognize DTA only to the extent future taxable profit is probable; No separate allowance account. The asset is reduced directly, and the reduction can be reversed.
Deferred tax asset from a tax loss: DTA = unused tax loss × enacted tax rate; Use the rate expected to apply when the loss is used.
Effect on income: Increase in allowance → higher tax expense → lower net income; A decrease (reversal) has the opposite effect. Cash taxes paid do not change.

How to solve Valuation Allowance and Tax Loss Carryforwards questions

Use this order for any question on valuation allowances or loss carryforwards.

1Identify the framework: US GAAP (valuation allowance) or IFRS (recognition if probable).
2Calculate the gross DTA: unused loss or deductible difference × enacted tax rate.
3Read the evidence on future taxable profit: past losses, forecasts, reversing taxable differences, tax planning.
4Apply the test: over 50% chance of non-realization under US GAAP, or recovery not probable under IFRS.
5Compute the allowance or write-down, then the net DTA on the balance sheet.
6Trace the effect: a larger allowance raises tax expense and lowers net income, equity and the DTA. A smaller one does the reverse.
7Check that cash taxes are unchanged. Only the accounting entry moves.

Quickest way: Three-check shortcut

When to use it: Use it when the question gives a loss, a rate and a probability statement and asks for the effect on income or the balance sheet.

Gross DTA = loss × rate.
Ask whether the evidence says non-realization is likely (over 50%) or recovery is unlikely.
If yes, the net DTA falls and tax expense rises by the same amount. If a prior allowance is reversed, the opposite happens.

Common mistakes in Valuation Allowance and Tax Loss Carryforwards

Saying a valuation allowance reduces cash taxes paid or cash flow.
Students link tax with cash.
Fix: The allowance is a non-cash accounting entry. It changes tax expense and the DTA, not taxes paid.
Applying the allowance when the chance of non-realization is exactly 50% or just below.
The threshold wording is misremembered.
Fix: The US GAAP test is more likely than not, meaning above 50%. At 50% or less, no allowance is required.
Using a valuation allowance under IFRS.
Both frameworks are mixed together.
Fix: IFRS recognizes the DTA only to the extent use is probable. The reduction is made directly to the asset.
Multiplying the loss by the wrong tax rate or using the loss itself as the asset.
Students forget that the asset is the tax saving.
Fix: DTA = loss × enacted rate. A ₹/$ 1,000 loss at 30% gives a DTA of 300, not 1,000.
Thinking an increase in the allowance raises net income.
The balance sheet entry is confused with the income effect.
Fix: A larger allowance means more tax expense and lower net income. A reversal raises net income.

Worked examples

Example 1

A US GAAP company has an unused tax loss of $2,000,000 and an enacted tax rate of 25%. Based on its loss history, management expects that 60% of the loss will not be used and judges it more likely than not that this part will go unrealized. What is the net deferred tax asset reported? (A) $200,000 (B) $300,000 (C) $500,000

Show the solution

Gross DTA = $2,000,000 × 25% = $500,000.
It is more likely than not that 60% of the loss will go unrealized, so an allowance is required for that portion.
Allowance = 60% × $500,000 = $300,000.
Net DTA = $500,000 − $300,000 = $200,000.

Answer: (A) Net DTA of $200,000.

Example 2

A company has a valuation allowance of $400,000 on a DTA. Strong profits make realization likely, so the entire $400,000 allowance is reversed in the current year. There are no other deferred tax changes this year. Pre-tax income is $1,000,000 and current tax is $300,000. What is net income under US GAAP? (A) $700,000 (B) $1,000,000 (C) $1,100,000

Show the solution

There are no other deferred tax items, so the only deferred tax effect is the allowance reversal.
Reversing the entire $400,000 allowance gives a deferred tax benefit of $400,000.
Total tax expense = current tax − deferred tax benefit = $300,000 − $400,000 = −$100,000, a net tax benefit.
Net income = $1,000,000 − (−$100,000) = $1,100,000.
Cash taxes paid stay at $300,000.

Answer: (C) Net income is $1,100,000.

Exam tips

Check the framework first. The word allowance signals US GAAP. Recognition if probable signals IFRS.
Remember the direction: a bigger allowance lowers net income, and a reversal lifts it.
Watch for statements that the allowance changes cash flow. These are wrong.
Evidence questions: a history of losses points to an allowance, and expected reversal of taxable differences points against one.
Eliminate options by the sign of the effect first, then confirm the amount.

Practice questions from Analysis of Income Taxes

Valuation Allowance and Tax Loss Carryforwards: frequently asked questions

When is a valuation allowance required?

Under US GAAP, it is required when it is more likely than not, meaning above 50%, that some or all of the deferred tax asset will not be realized. The allowance covers only the portion not expected to be realized.

How are tax loss carryforwards treated on the balance sheet?

They give rise to a deferred tax asset equal to the unused loss times the enacted tax rate. The asset is recognized if future taxable profit is likely enough to use it. Otherwise it is reduced or not recognized.

Does IFRS have a valuation allowance?

No. IFRS recognizes a deferred tax asset only to the extent it is probable that taxable profit will be available. The carrying amount is reviewed each period and written down if recovery is no longer probable.

How does a valuation allowance affect the income statement?

Increasing the allowance raises income tax expense and lowers net income. Reversing it lowers tax expense and raises net income. Cash taxes are not affected.