How should an analyst evaluate changes in the DTA valuation allowance?

The valuation allowance (VA) on a deferred tax asset is one of the most subjective estimates on the balance sheet. Changes in the VA provide important signals about management's view of future profitability and can be used for earnings management.

What Triggers a Valuation Allowance Change?

Under US GAAP (ASC 740), a DTA must be reduced by a valuation allowance if it is "more likely than not" (> 50% probability) that some or all of the DTA will not be realized. Sources of evidence include:

Positive Evidence (reduce VA):

• Existing contracts or orders ensuring future revenue
• Track record of profitable operations
• Temporary differences that will reverse and create taxable income
• Tax planning strategies available

Negative Evidence (increase VA):

• Cumulative losses in recent years
• Operating losses expected in the near term
• History of tax benefits expiring unused
• Unsettled circumstances that could negatively impact operations

Analytical Framework:

Example -- Ridgecrest Biotech:

Year 1: Ridgecrest has a $30M gross DTA but records a full $30M VA due to cumulative losses.

Year 2: After FDA approval of a key drug, management releases $20M of the VA.

Impact: Tax expense in Year 2 drops by $20M, boosting net income by $20M. But this is a non-cash, non-operating benefit. Analysts should:

1. Exclude the VA release from recurring earnings
2. Question whether the release is justified by expected future taxable income
3. Monitor subsequent quarters to see if the drug actually generates profits

Red Flags:

• Releasing the VA in a quarter where the company would otherwise miss earnings targets
• Partial releases timed to smooth earnings over multiple quarters
• VA reductions not supported by changes in business fundamentals

Exam Tip: CFA Level II frequently tests whether a VA change is justified and how it impacts the effective tax rate and earnings quality.

Explore deferred tax analysis in our CFA Level II question bank.