Releasing the Allowance Is Management Predicting Its Own Profits
A company with accumulated losses holds a tax asset it can only use against future profits. Whether it recognises that asset depends on management judgement about whether those profits will arrive.
Losses Are Worth Money Only If You Recover
A company that loses money generally accumulates net operating loss carryforwards, which can be used to offset taxable income in future years. Other differences between accounting and tax treatment produce similar future benefits.
Together these are deferred tax assets, and they sit on the balance sheet as an asset because they will reduce future tax payments.
The obvious problem is that they only have value if there is future taxable income to offset. A company that never earns a profit again will never use them, and an asset that will never be realised is not an asset.
The Allowance Is a Judgement Recorded as a Number
Accounting standards address this by requiring a valuation allowance reducing the deferred tax asset to the amount that is more likely than not to be realised, meaning a probability greater than fifty percent.
That threshold requires management to form and record a view about future profitability. The evidence considered is prescribed in outline: recent history of profits or losses, projections of future income, the expiry schedule of the carryforwards, and available tax planning strategies.
Standards specify that objective, verifiable evidence carries more weight than projections, and a cumulative loss over the recent three year period is described as significant negative evidence that is difficult to overcome. A company with three years of losses claiming that next year will be profitable is asking auditors to weight a forecast above an observed record, and the standards say not to.
| Evidence | Weight |
|---|---|
| Cumulative losses in recent years | Strong negative, hard to overcome |
| History of carryforwards expiring unused | Negative |
| Existing contracts or backlog producing future income | Positive and objective |
| Management projections of a turnaround | Positive but subjective |
The allowance forces management to state, in a number, whether it believes the company will be profitable enough to use its own losses. Very few disclosures require an explicit forecast, and this one does it every reporting period.
The Release Is a Large Non Cash Gain
When a company returns to sustained profitability and concludes the assets will now be used, it reverses the allowance. The reversal runs through the income statement as a tax benefit.
The effect can be dramatic. A company earning modest operating profit can report enormous net income in the quarter it releases a large allowance, entirely from a non cash accounting entry recognising assets it already had.
Two consequences follow that catch people out. The reported earnings figure in that period is not repeatable and should be excluded from any run rate. And the following periods will show a much higher effective tax rate, because the company now records tax expense on its profits even though it may still pay little cash tax while consuming the carryforwards.
That gap between book tax expense and cash tax paid persists until the carryforwards are exhausted, and it makes reported earnings understate cash generation for years.
The Signal Value
Because release requires a documented conclusion that sustained profitability has arrived, and because auditors scrutinise it heavily given the earnings impact, it is a relatively credible signal.
Management cannot release the allowance simply because it is optimistic. It generally needs to have emerged from cumulative losses and to support the conclusion with evidence. The release therefore usually confirms a turnaround that has already happened rather than predicting one.
The reverse signal is equally informative and less discussed. A company establishing a valuation allowance is stating that it no longer expects to earn enough to use its tax assets, which is a serious admission delivered in a tax footnote. It produces a large non cash charge and it frequently precedes broader deterioration.
The Complication That Can Destroy the Asset
Carryforwards are not permanently secure. Tax rules limit the use of losses after an ownership change, broadly a substantial shift in ownership over a rolling period, restricting the annual amount usable to a formula based on the value of the company and a prescribed rate.
The practical effect is that a loss making company acquired, or that raises substantial equity, can find a large portion of its accumulated tax assets effectively stranded. This is a real consideration in acquisitions of loss making targets, and it is why some companies adopt charter provisions restricting large share accumulations specifically to protect the carryforwards.
What to Look For
The tax footnote repays reading in a small number of situations. A company emerging from losses, where release is plausible and would inflate a coming quarter. A company with a large gross deferred tax asset fully allowanced, which represents optionality that appears nowhere in earnings. A newly established allowance, which is a negative statement about the future made quietly. And any disclosure about ownership change limitations, which can quietly reduce the value of the asset regardless of profitability.
The Bottom Line
A valuation allowance is management writing down its own tax assets because it does not expect to earn enough to use them, and releasing it is management stating the opposite. The release produces a one time earnings gain that should be ignored and a permanently higher effective tax rate that should not, since reported tax expense will exceed cash tax paid for years afterward. Both the establishment and the release are among the more honest forecasts a company publishes, largely because auditors will not let them be anything else.