The Q3 2026 valuation allowance assessment is happening in the most technically demanding operating environment for ASC 740 in recent memory. Three forces are converging simultaneously that make the more-likely-than-not analysis harder to support and easier to challenge.
OBBBA's first full year of effect. The OBBBA's 100% bonus depreciation, Section 174A immediate R&E expensing, and Section 163(j) EBITDA restoration are repricing the reversing deferred tax liability schedules that many companies use as their primary source of taxable income to support DTA realizability. Alta Equipment Group recorded a $24.5 million valuation allowance charge in 2025 specifically after incorporating OBBBA bonus depreciation into its assessment. Flotek Industries released $15.5 million of valuation allowance in the same period because OBBBA bonus depreciation made DTAs realizable again. The same standard change cuts both ways depending on the company's specific DTA and DTL mix.
Tariff and Iran war margin compression fully entering the three-year cumulative window. The 12-quarter rolling look-back that determines whether a company is in a cumulative loss position under ASC 740-10-30-23 now includes Q3 2025 forward, which for many companies includes the tariff-driven margin compression of 2025 and the Iran war supply chain disruption costs of 2026. Goodyear Tire and Rubber established a $1.4 billion full valuation allowance in Q3 2025 citing tariff, transportation, labour, and energy costs. Those conditions, and the companies that share them, remain in the three-year window for Q3 2026 assessments.
SEC and PCAOB pressure from both directions. The SEC's comment letter to Tesla in September 2023 pushed back on Tesla's initial reluctance to release its valuation allowance despite three years of profitability, with a $5.9 billion income impact on release. ServiceNow maintained a $1.2 billion valuation allowance while profitable, drawing similar scrutiny. A ScienceDirect academic study published May 2025 analysed PCAOB inspection findings and confirmed that auditor professional scepticism on deferred tax asset valuation allowances is a recurring high-judgment audit deficiency area in PCAOB inspections.
This post covers what the more-likely-than-not standard requires, what makes Q3 2026 uniquely high-risk, and the seven specific red flags auditors are focusing on in Q3 2026 assessments.
What Is an ASC 740 Valuation Allowance and What Does "More Likely Than Not" Actually Require?
Under ASC 740-10-30-5, a deferred tax asset is recognised for deductible temporary differences, carryforwards of operating losses, and carryforwards of tax credits. The DTA represents the expected future tax benefit of those items. But a DTA is only an asset if the benefit is expected to be realised, meaning the company will have sufficient future taxable income to use the deductions or credits before they expire.
ASC 740-10-30-16 requires a valuation allowance to be established against the portion of a deferred tax asset that is more likely than not to not be realised. More likely than not means a probability greater than 50% that the DTA will not be realised. The valuation allowance reduces the net DTA on the balance sheet to the amount that is more likely than not to be realised.
The assessment is not a binary choice between full VA and no VA. The Deloitte DART ASC 740 Chapter 5 confirms: the more-likely-than-not threshold applies to each deferred tax asset individually (though in practice, assessments are often made at the jurisdictional or carve-out level based on how taxable income is generated and used). A company may maintain a partial valuation allowance against specific DTA types (for example, against foreign tax credit carryforwards) while releasing a VA against other DTAs (for example, operating loss carryforwards that will be used against reversing DTLs).
The four sources of taxable income that can be considered when assessing DTA realizability are specified in ASC 740-10-30-18:
Future reversals of existing taxable temporary differences (reversing DTLs).
Future taxable income exclusive of reversing temporary differences and carryforwards.
Taxable income in prior carryback years if carryback is permitted under tax law.
Tax-planning strategies that would create additional taxable income.
The sequence matters. Reversing DTLs are the most objective source of taxable income because they do not depend on a forecast about future operating results. Future taxable income from operations is the most subjective source because it requires a forecast that auditors will scrutinise.
Why Q3 2026 Is a Higher-Risk Period for Valuation Allowance Assessments Than Any Recent Quarter
Three factors converge in Q3 2026 to make the VA assessment more challenging than it has been in recent years.
First, OBBBA's full-year effect on reversing DTL schedules is now being assessed for the first time on a complete annual basis. Q1 and Q2 2026 were the first quarters under OBBBA's new rules, and many companies deferred a comprehensive DTL schedule revision until the tax return positions were finalised. The Q3 2026 tax provision requires a fully updated DTL reversing schedule that incorporates OBBBA's Section 174A expensing, 100% bonus depreciation, and Section 163(j) changes. For companies that relied on reversing DTLs from TCJA-era capitalised R&E or pre-OBBBA bonus depreciation timing differences to support DTA realizability, those DTLs may reverse faster or slower than previously modelled, changing the taxable income available to support DTAs.
Second, the 12-quarter cumulative loss window at Q3 2026 covers the period from Q4 2023 through Q3 2026. That window includes: the tariff-driven margin compression that started in 2025, the Iran war fuel and logistics cost increases from Q1 2026, and the ceasefire period inventory and supply chain costs of Q2 2026. Companies in manufacturing, transportation, food processing, retail, and other import-dependent industries that experienced sustained margin compression through this period may now be in a cumulative pretax loss position that activates the strong negative evidence standard under ASC 740-10-30-23.
Third, auditors completing their Q3 2026 reviews are operating with enhanced scrutiny on ASC 740 following PCAOB inspection findings that identified valuation allowance assessments as a recurring area of inadequate professional scepticism. The ScienceDirect study confirmed that auditors with more accounting knowledge about deferred taxes, specifically those familiar with the four sources of income test and the cumulative loss indicator, are more sceptical in their review of management's VA conclusions. Those auditors will ask harder questions in Q3 2026 than in prior periods.
Red Flag #1: Three-Year Cumulative Pretax Loss, Is Your 12-Quarter Window Now in Loss Territory?
ASC 740-10-30-23 specifies that a cumulative loss in recent years (specifically cumulative pretax financial reporting income or loss for the prior three years) is a significant piece of negative evidence that makes it difficult to conclude that a full valuation allowance is not needed. This is the single most powerful negative evidence indicator in the ASC 740 framework.
The three years is measured as the most recent 12 quarters of pretax income or loss on a cumulative basis. If the sum of the pretax income or loss for the 12 most recent quarters is negative, the company is in a three-year cumulative loss position, and the presumption shifts strongly toward establishing a full valuation allowance.
The Bloomberg Tax analysis confirms: it generally would be difficult for a company to conclude it has no need for a valuation allowance when it has experienced a cumulative loss in recent years. Overcoming this presumption requires strong, objectively verifiable positive evidence, not just a forecast of future profitability.
For Q3 2026, the 12-quarter window now extends back to Q4 2023. Companies that were moderately profitable through 2023 and 2024 but experienced significant losses in 2025 due to tariffs, and further losses in Q1 and Q2 2026 due to Iran war-related cost increases, may find their cumulative 12-quarter sum turning negative.
Two specific Q3 2026 triggers to assess:
Has the 12-quarter cumulative pretax income fallen below zero? If yes, this is a significant piece of negative evidence under ASC 740-10-30-23.
Has the 12-quarter cumulative pretax income, while still positive, declined significantly from the prior quarter? A declining trend can itself be negative evidence that the current positive cumulative position may not be sustained.
The Goodyear example is instructive: when Goodyear established its $1.4 billion full valuation allowance in Q3 2025, the company had experienced sustained losses driven by the exact cost categories now affecting Q3 2026 assessments for other companies: tariffs, transportation, labour, and energy. The Q3 2026 tax team should model the 12-quarter cumulative loss window with Q3 2026 actual results before concluding the assessment.
Red Flag #2: OBBBA Changed Your Reversing DTL Schedule, Did You Update Your Taxable Income Sourcing Analysis?
This is the highest-frequency technical error the Deep Quarry/Nonlinear Analytics analysis identifies as a red flag in Q3 2026. Companies that completed their valuation allowance reassessment in Q3 or Q4 2025, when OBBBA was enacted in July 2025, may have incorporated OBBBA's changes imprecisely or incompletely into their reversing DTL schedule.
The OBBBA changes that most commonly affect the reversing DTL schedule used as a taxable income source:
Section 174A immediate R&E expensing. Companies that had large deferred tax assets from TCJA-era capitalised R&E may have elected the 50/50 transition over 2025 and 2026, reducing the taxable income in those years from the accelerated deduction. The reversing DTL previously expected to generate taxable income from R&E amortisation may now be reversing at a different pace. The R&E-related DTL schedule needs to be rebuilt from scratch with the current OBBBA position.
100% bonus depreciation. Companies with new capital expenditure programs will be getting 100% bonus depreciation on qualifying assets, creating new DTLs for assets placed in service in 2025 and 2026. Whether those new DTLs are reversing DTLs that can offset existing DTAs depends on the timing of their reversal relative to the DTA carryforward period.
Section 163(j) EBITDA restoration. Companies that previously had large interest expense carryforward DTAs because the EBIT-based limitation was producing persistent disallowance may now have higher deductible interest under the EBITDA restoration, reducing the carryforward DTA going forward. Whether the higher deductibility improves VA assessments depends on whether the existing carryforward DTA was itself subject to a valuation allowance.
The Baker Tilly Q4 ASC 740 update specifically flagged the Section 163(j) EBITDA restoration and the CAMT interaction as areas requiring explicit analysis in the valuation allowance sourcing assessment.
The auditor's question: show me your reversing DTL schedule and confirm it has been updated for OBBBA. Companies that cannot produce an OBBBA-adjusted reversing DTL schedule by Q3 2026 are more than a year into OBBBA's effective date. Auditors will not accept an analysis that predates the OBBBA adjustments.
Red Flag #3: You Are Profitable But Still Carrying a Full Valuation Allowance, The Tesla Problem
The SEC's comment letter to Tesla dated September 26, 2023, is the most high-profile example of the SEC pushing back on a company that maintained a full valuation allowance while demonstrating sustained profitability. Tesla had been profitable for multiple consecutive quarters and had generated substantial cumulative pretax income by the time of the comment letter. The SEC asked Tesla to explain how it concluded that a full valuation allowance was appropriate given the positive evidence of sustained profitability.
Tesla subsequently released its full valuation allowance in Q4 2023, resulting in a $5.9 billion income statement benefit.
The principle the SEC comment letter illustrates: the more-likely-than-not standard applies in both directions. Just as a company in cumulative losses is presumed to need a full VA, a company with sustained profitability faces scrutiny if it maintains a full or nearly full VA without compelling negative evidence.
The Nonlinear Analytics analysis published June 9, 2026 specifically identifies companies carrying large valuation allowances despite sustained profitability as likely targets for the next wave of VA releases, analogising to the Tesla pattern. It names ServiceNow, which maintained a $1.2 billion valuation allowance while profitable, as a company that faced similar questions.
For Q3 2026, this red flag applies to any company that:
Has been profitable on a three-year cumulative basis.
Maintains a significant valuation allowance.
Has not performed a comprehensive reassessment of the VA in light of the OBBBA changes.
The auditor's question in this scenario: what negative evidence justifies maintaining the full VA given the pattern of profitability? Companies should have a documented answer, supported by specific negative evidence that is still relevant as of Q3 2026.
Red Flag #4: Your Taxable Income Forecast Assumes an Oil Price or Margin That No Longer Reflects Current Reality
When a company relies on future taxable income from operations (the most subjective of the four income sources) to support DTA realizability, the taxable income forecast used in the assessment is subject to direct auditor scrutiny. The forecast must be consistent with the company's current operating environment and must not embed assumptions that are inconsistent with observable market conditions.
For Q3 2026, the relevant observable market conditions are specific and unfavourable for many companies:
Oil prices were approximately $73 per barrel at June 30, 2026, up from the pre-war level of approximately $63 but materially below the Q1 peak near $120. Companies whose taxable income forecasts embed specific oil price assumptions must update those assumptions to reflect the current environment.
The ceasefire collapse on July 8 introduced new uncertainty about whether oil prices will stabilise at current levels, increase toward $100-plus again, or fall back toward the ceasefire-era $63 to $70 range.
Tariff costs remain elevated for most importers despite the IEEPA ruling, as Section 301 and Section 232 tariffs persist.
A taxable income forecast that was prepared in Q4 2025 or Q1 2026 using oil price or margin assumptions that do not reflect the Q3 2026 operating reality is not a valid basis for the VA assessment. Auditors will ask when the forecast was last updated and whether the assumptions are consistent with the current operating environment.
The Exactera documentation guidance confirms: where a company relies on future taxable income projections, the projections must be supported by verifiable evidence, consistent with the company's historical ability to generate taxable income, and free from optimistic assumptions that are not supportable based on current conditions.
Red Flag #5: CAMT Created a DTA You Cannot Realize, Did You Evaluate It Separately?
The Corporate Alternative Minimum Tax, enacted in the IRA at 15% on adjusted financial statement income (AFSI), creates a separate category of deferred tax assets and liabilities that require valuation allowance assessment under ASC 740.
CAMT generates DTAs in two primary situations: CAMT is paid in a year when CAMT exceeds regular tax (creating a minimum tax credit DTA), or CAMT-adjusted book income exceeds CAMT taxable income in a way that creates temporary differences that will reverse in future years.
The realizability of CAMT DTAs is assessed separately from the realizability of regular income tax DTAs. The Baker Tilly ASC 740 update specifically flagged the CAMT DTA as requiring explicit analysis: "Did you evaluate the CAMT DTA separately from the regular income tax DTA for valuation allowance purposes?"
CAMT DTAs may be at risk in Q3 2026 for several specific reasons:
CAMT minimum tax credit carryforwards are only realizable against regular income tax in future years. A company that pays CAMT in 2026 creates a minimum tax credit that can only be used when regular income tax exceeds CAMT in a future year. If the company's regular tax position is uncertain, the realizability of the minimum tax credit DTA may require a valuation allowance even if the company has sufficient regular taxable income to support its other DTAs.
AFSI adjustments under Notice 2026-7 (the CAMT Notice) create timing differences between CAMT and regular tax that may reverse at different rates than expected based on the OBBBA changes. A company that updated its regular tax reversing DTL schedule for OBBBA but did not separately update its CAMT AFSI timing analysis may have a CAMT DTA that is not supportable under the revised schedule.
For Q3 2026 assessments, the tax team should explicitly document: (1) the current CAMT DTA balance, (2) the source of the CAMT DTA (minimum tax credit vs AFSI timing difference), (3) the specific taxable income source that supports realizability of the CAMT DTA, and (4) why that source is not subject to the same uncertainty as the regular income tax DTA.
Red Flag #6: You Released a Valuation Allowance Based on One Quarter of Profitability After Years of Losses
The more-likely-than-not standard for VA release is at least as demanding as the standard for VA establishment. Releasing a valuation allowance requires the company to conclude that it is more likely than not that the DTA will be realised. A single quarter of profitability after years of losses is generally not sufficient positive evidence to overcome the negative evidence of a cumulative loss history.
The Exactera guidance is specific: a single quarter of profitability after years of losses is often not sufficient positive evidence to release a valuation allowance. The release requires a sustained pattern of profitability, a change in circumstances that is objectively verifiable, and evidence that the prior negative evidence is no longer applicable.
For Q3 2026, several specific situations where a premature VA release may be challenged:
A company that recorded a VA in 2025 due to tariff-driven margin compression and then became profitable in Q2 2026 as oil prices fell during the ceasefire period. If profitability in Q2 was driven by temporary ceasefire-related price relief and the Q3 operating environment has deteriorated again following the July 8 ceasefire collapse, the Q2 profitability may not constitute sustained positive evidence of DTA realizability.
A company that released a VA in Q1 2026 based on the expectation that OBBBA bonus depreciation would create reversing DTLs that support DTA realizability, but that has not yet verified the DTL reversal timing in its updated deferred tax schedule.
Auditors will specifically ask: what has changed between the period of losses and the decision to release the VA? The answer must be a sustained and objectively verifiable change in circumstances, not a single quarter of improved results that may not persist.
Red Flag #7: Your Documentation Does Not Distinguish Between Objective and Subjective Evidence, The PCAOB's Specific Complaint
The PCAOB 2025 Annual Report identified ASC 740 as a recurring high-judgment audit deficiency area. The ScienceDirect study published in May 2025 confirmed that the specific PCAOB finding relates to auditor professional scepticism on the valuation allowance: auditors were not sufficiently challenging management's use of subjective future income projections to overcome objective negative evidence (such as cumulative losses or declining trends).
The distinction between objective and subjective evidence is defined in the ASC 740 framework itself:
Objective evidence is verifiable from external sources or from historical facts. Examples include: the company's actual cumulative pretax income or loss for the past three years, the current reversing DTL schedule based on enacted tax law, actual carryback capacity based on filed tax returns, and the terms of specific tax-planning strategies that are documented and executable.
Subjective evidence relies on management's judgment about future events. Examples include: management's forecast of future taxable income from operations, management's expectation that the current operating environment will improve, and management's belief that a specific business strategy will generate additional taxable income.
ASC 740-10-30-22 is explicit: a history of operating loss or tax credit carryforwards in recent years is a specific indicator that a valuation allowance may be needed. The standard further requires that where negative evidence exists in the form of cumulative losses, the weight of evidence required to overcome it must be both strong and positive (meaning objectively verifiable) rather than merely optimistic or speculative.
The PCAOB complaint is that auditors allowed management to use subjective future income projections to overcome objective cumulative loss evidence without requiring sufficient corroboration of those projections.
For Q3 2026 valuation allowance memos, the documentation must explicitly separate objective and subjective evidence. The memo should identify what objective evidence supports or contradicts the VA conclusion and should describe what additional corroboration is available for any subjective evidence relied upon. A memo that lists future income projections without distinguishing them from objective evidence is exactly what PCAOB inspectors have flagged.
What Your Q3 2026 Valuation Allowance Memo Must Include to Survive Auditor Scrutiny
The Q3 2026 valuation allowance memo needs to address seven specific elements to withstand enhanced auditor scrutiny in the current environment.
The updated reversing DTL schedule. The schedule must reflect OBBBA's Section 174A, 100% bonus depreciation, and Section 163(j) changes. It must show the timing of each DTL's expected reversal, the amount of taxable income it generates, and how that taxable income is matched to specific DTA carryforwards. An OBBBA-adjusted reversing DTL schedule is the most objective taxable income source and should be presented first.
The 12-quarter cumulative pretax income calculation. Reproduce the actual pretax income or loss for each of the 12 quarters in the look-back period, with the cumulative sum clearly identified. If the cumulative sum is negative, the memo must address what strong, objectively verifiable positive evidence overcomes this significant negative evidence.
The CAMT DTA analysis. Identify the CAMT DTA balance, its source, and the specific taxable income source supporting its realizability. Document that this analysis was performed separately from the regular income tax DTA assessment.
The operating environment update. Describe the current operating environment as of Q3 2026, including the effect of the Iran war oil price cycle, tariff costs, and any other material developments. Confirm that the taxable income forecast, if relied upon, has been updated to reflect current conditions.
The objective vs subjective evidence inventory. Explicitly categorise each piece of positive and negative evidence as objective or subjective. Where subjective evidence is relied upon, describe the corroboration available.
The comparison to prior-quarter assessment. Describe what, if anything, changed from the prior quarter's VA conclusion and why. If the conclusion did not change, explain why the current quarter's developments do not alter the assessment.
The critical audit matter consideration. If the VA is likely to be designated as a critical audit matter in the Q3 review or year-end audit, confirm that the documentation supports the audit committee discussion required for a CAM disclosure. McEwen Inc.'s $116 million VA designation as a critical audit matter in its FY2025 10-K, per EDGAR, is an example of the level of auditor focus a large VA attracts.
Frequently Asked Questions
What triggers an ASC 740 valuation allowance assessment in Q3 2026?
Any change in circumstances that affects the expectation of whether deferred tax assets will be realised requires a reassessment of the valuation allowance. For Q3 2026, the specific triggers are: OBBBA changes to the reversing DTL schedule (first full year), tariff and Iran war cost impacts on cumulative pretax income, the 12-quarter cumulative loss window, CAMT DTA balances requiring separate analysis, and new SEC comment letter and PCAOB inspection pressure on both VA establishment and VA release decisions.
What is the three-year cumulative loss test under ASC 740?
ASC 740-10-30-23 specifies that a cumulative loss in recent years (the 12 most recent quarters of pretax financial reporting income or loss) is a significant piece of negative evidence that makes it difficult to conclude a full valuation allowance is not needed. The three-year cumulative loss position does not automatically require a full VA, but it creates a strong presumption that a VA is appropriate, and overcoming that presumption requires strong, objectively verifiable positive evidence.
Does the OBBBA require companies to reassess their valuation allowance?
OBBBA does not explicitly require a VA reassessment, but ASC 740 requires that the VA be reassessed whenever there is a change in circumstances that affects the probability of realising a deferred tax asset. OBBBA's changes to bonus depreciation, Section 174A R&E expensing, and Section 163(j) change the reversing DTL schedule that serves as the most objective taxable income source for DTA realizability. Any change to the reversing DTL schedule requires a reassessment of whether the VA is appropriate.
What did the SEC say to Tesla about its valuation allowance?
In a comment letter dated September 26, 2023, the SEC asked Tesla to explain how it concluded a full valuation allowance was appropriate given its history of sustained profitability. The SEC's letter reflected the principle that the more-likely-than-not standard applies in both directions: just as cumulative losses are negative evidence for VA establishment, sustained profitability is positive evidence for VA release. Tesla released its full valuation allowance in Q4 2023, recording a $5.9 billion income statement benefit.
What is the difference between objective and subjective evidence in an ASC 740 VA assessment?
Objective evidence is verifiable from external sources or historical facts, such as the actual 12-quarter cumulative pretax income, the reversing DTL schedule derived from enacted tax law, or the terms of an executable tax-planning strategy. Subjective evidence relies on management's judgment about future events, such as management's forecast of future taxable income from operations. ASC 740-10-30-22 requires that where objective negative evidence exists (such as cumulative losses), it can only be overcome by strong, objectively verifiable positive evidence, not by subjective optimistic forecasts.
Can a company maintain a full valuation allowance if it has been profitable for three years?
It is possible but difficult to justify. The more-likely-than-not standard requires the company to assess all available evidence. Three years of profitability is significant positive evidence that DTAs are realizable. Maintaining a full VA despite sustained profitability requires compelling negative evidence that is still relevant as of the assessment date. The SEC has pushed back on companies that maintained full VAs despite sustained profitability without adequate negative evidence.
What documentation does an auditor expect to see for a valuation allowance conclusion?
An updated reversing DTL schedule reflecting current tax law including OBBBA, the 12-quarter cumulative pretax income calculation, an explicit inventory of positive and negative evidence categorised as objective or subjective, the taxable income forecast with current-environment assumptions, the CAMT DTA analysis performed separately, the comparison to the prior-quarter assessment, and documentation of why subjective evidence is corroborated by objective factors where subjective evidence is relied upon.
Key Takeaways
- Q3 2026 is a higher-risk period for valuation allowance assessments than any recent quarter, due to OBBBA's first full year of effect on reversing DTL schedules, tariff and Iran war costs entering the three-year cumulative loss window, and heightened SEC and PCAOB scrutiny on valuation allowance conclusions in both directions.
- Three-year cumulative pretax losses are strong negative evidence under ASC 740-10-30-23. Companies whose 12-quarter cumulative pretax income has turned negative or is declining significantly face the highest presumption of needing a full valuation allowance.
- OBBBA's changes to Section 174A, 100% bonus depreciation, and Section 163(j) change the reversing DTL schedule that forms the most objective taxable income source. Any company that has not updated its reversing DTL schedule for OBBBA by Q3 2026 is using a stale analysis.
- Companies profitable for three years but maintaining a full VA face SEC comment letter risk. The Tesla $5.9 billion VA release following SEC questioning in 2023 established the principle that the more-likely-than-not standard applies to both VA establishment and VA release.
- CAMT DTAs require separate evaluation from regular income tax DTAs. The Baker Tilly ASC 740 update confirmed that the realizability of CAMT minimum tax credit carryforwards must be assessed independently.
- The PCAOB's specific complaint about auditor scepticism on VA assessments is that auditors allowed subjective future income projections to overcome objective cumulative loss evidence. Q3 2026 VA memos must explicitly categorise positive and negative evidence as objective or subjective.
- The Q3 2026 VA memo must include: OBBBA-adjusted reversing DTL schedule, 12-quarter cumulative income calculation, CAMT DTA separate analysis, current-environment taxable income forecast, objective vs subjective evidence inventory, comparison to prior quarter, and critical audit matter documentation if applicable.
