#ASC740 #SALT #Taxes
ASC 740-10-30-2(b) states that the measurement of deferred tax assets is reduced, if necessary, by the amount of any tax benefits that, based on the evaluation of available evidence, are not expected to be realized. Determining whether a valuation allowance for deferred tax assets is necessary often requires an extensive analysis of positive and negative evidence regarding the realization of the deferred tax assets and, inherent in that, an assessment of the likelihood of sufficient future taxable income. This analysis typically includes determining the refund potential in the event of NOL carrybacks, scheduling reversals of temporary differences, evaluating potential tax-planning strategies and evaluating expectations of future profitability.
A valuation allowance is recognized if, based on the weight of available evidence, it is more likely than not (likelihood of more than 50 percent) that some portion, or all, of the deferred tax asset will not be realized (ASC 740-10-30-5(e)). It is important to emphasize that the evaluation regarding realizability of deferred tax assets is made on a gross as opposed to a net basis. In other words, all companies with significant deductible temporary differences and operating loss and tax credit carryforwards are required to evaluate the realizability of their deferred tax assets, not only those companies in a net deferred tax asset position.
Additionally, the need for a valuation allowance should be determined for each individual entity (or group of entities that are consolidated for tax purposes) in each jurisdiction and tax-paying component. Therefore, a company in a consolidated net deferred tax liability position still needs to determine whether the nature and character of existing deferred tax liabilities provide an appropriate source of future taxable income for the deferred tax assets in each individual entity (or group of entities that are consolidated for tax purposes).
Companies that have historically been profitable and expect that trend to continue need less judgment to conclude the future realization of deferred tax assets is more likely than not to occur. However, the assessment is more difficult when there is negative evidence, which generally is the case for unprofitable companies, marginally profitable companies, or companies experiencing a high degree of volatility in earnings. Further discussion about evaluating the realizability of deferred tax assets in those situations is included in this chapter.
1. Evaluation of positive and negative evidence —
| Excerpt From Accounting Standards Codification |
| Income Taxes—Overall |
| Initial Measurement |
| 740-10-30-21 |
| Forming a conclusion that a valuation allowance is not needed is difficult when there is negative evidence such as cumulative losses in recent years. Other examples of negative evidence include, but are not limited to, the following: |
| a. A history of operating loss or tax credit carryforwards expiring unused |
| b. Losses expected in early future years (by a presently profitable entity) |
| c. Unsettled circumstances that, if unfavorably resolved, would adversely affect future operations and profit levels on a continuing basis in future years |
| d. A carryback, carryforward period that is so brief it would limit realization of tax benefits if a significant deductible temporary difference is expected to reverse in a single year or the entity operates in a traditionally cyclical business. |
| 740-10-30-22 |
| Examples (not prerequisites) of positive evidence that might support a conclusion that a valuation allowance is not needed when there is negative evidence include, but are not limited to, the following: |
| a. Existing contracts or firm sales backlog that will produce more than enough taxable income to realize the deferred tax asset based on existing sales prices and cost structures |
| b. An excess of appreciated asset value over the tax basis of the entity's net assets in an amount sufficient to realize the deferred tax asset |
| c. A strong earnings history exclusive of the loss that created the future deductible amount (tax loss carryforward or deductible temporary difference) coupled with evidence indicating that the loss (for example, an unusual or infrequent item) is an aberration rather than a continuing condition. |
| 740-10-30-23 |
| An entity shall use judgment in considering the relative impact of negative and positive evidence. The weight given to the potential effect of negative and positive evidence shall be commensurate with the extent to which it can be objectively verified. The more negative evidence that exists, the more positive evidence is necessary and the more difficult it is to support a conclusion that a valuation allowance is not needed for some portion or all of the deferred tax asset. A cumulative loss in recent years is a significant piece of negative evidence that is difficult to overcome. |
| 740-10-30-24 |
| Future realization of a tax benefit sometimes will be expected for a portion but not all of a deferred tax asset, and the dividing line between the two portions may be unclear. In those circumstances, application of judgment based on a careful assessment of all available evidence is required to determine the portion of a deferred tax asset for which it is more likely than not a tax benefit will not be realized. |
The weight given to the potential effects of negative and positive evidence should be commensurate with the extent to which the evidence can be objectively verified. The further into the future the estimates go, the less objectively verifiable the evidence becomes. Furthermore, estimates about uncertain future events, such as future taxable income, are much less objectively verifiable than historical results, such as recent cumulative losses. The more negative the evidence, the more positive evidence is needed and the more difficult it will be to support a conclusion that a valuation allowance is not needed.
Assessing the evidence to determine the need for, and amount of, a valuation allowance requires the application of judgment. The most straightforward cases are those in which either no valuation allowance is deemed necessary because it is more likely than not that the full amount of the deferred tax asset will be realized or when the available evidence clearly indicates a full valuation allowance is deemed necessary because it is not more likely than not that the full amount of the deferred tax assets will be realized. Situations in which a benefit is expected for a portion, but not all, of the deferred tax asset are often more difficult to assess.
All available evidence, both positive and negative, should be considered in determining whether a valuation allowance is needed.
Examples of negative evidence include:
• Cumulative losses in recent years (see section 6.1.1.1, Cumulative losses)
• History of net operating losses or tax credit carryforwards expiring unused
• Unsettled circumstances which, if resolved unfavorably, would affect future operations and profits on a continuing basis in the future
• A carryforward (or carryback if permitted) is so brief it would limit realization of tax benefits if a significant deductible temporary difference is expected to reverse in a single year
Examples of positive evidence that might support the conclusion a valuation is not required include:
• Based on an entity's existing sales prices and cost structure there are existing contracts or firm sales backlog that will produce more than enough taxable income to realize the deferred tax assets
• Excess of the asset market value over the tax basis in an amount sufficient to realize a deferred tax asset and the company has the intent and ability to realize that excess amount
• A strong earnings history exclusive of the loss that created the future deductible amount (tax loss carryforward or deductible temporary difference) coupled with evidence indicating that the loss (for example, an unusual or infrequent item) is an aberration rather than a continuing condition (see section 6.1.1.1.1, Unusual, nonrecurring and noncash charges)
In addition to these examples, other factors may significantly influence the likelihood of realizing deferred tax assets. Economic conditions, both national and regional, play a major role in the evaluation of an entity's prospects of generating future taxable income. Although companies cannot be expected to have a crystal ball, evidence of expected future results may be gleaned from an analysis of data, such as:
• Concentrations of risk within specific industries and geographical areas
• Historical levels and trends in earnings
• Sensitivity analysis
In analyzing historical information, care should be taken to consider trends within the industry or for a particular company that may render some of the historical data somewhat irrelevant. Continuing consolidation within some industries, as well as potential cost-cutting through outsourcing or downsizing, for example, may be expected to significantly affect the future profitability of some companies. Actual results achieved to date under an existing operating plan would presumably be given much more weight than projected results under a pending plan.
a. Cumulative losses (updated September 2020) —
While this statement is not included in the Accounting Standards Codification, the FASB said, in the Basis for Conclusions of Statement 109 (non-authoritative), that it considered whether the criteria for recognizing deferred tax assets should be established at a higher level (such as “probable” or “assured beyond a reasonable doubt”) when there is a cumulative pretax loss for financial reporting for the current year and the two preceding years (i.e., a three-year cumulative loss). In this regard, the FASB concluded that more restrictive criteria were not necessary because a cumulative loss in recent years is a significant piece of negative evidence that would be difficult to overcome on a more-likely-than-not or any other basis. While the FASB also rejected the use of cumulative losses as a bright line (or “on/off switch”) requiring a valuation allowance, the FASB did specifically incorporate guidance in ASC 740-10-30-21 that forming a conclusion that a valuation allowance is not needed is difficult when there is significant negative evidence such as cumulative losses in recent years.
ASC 740 does not specifically define “cumulative losses in recent years.” However, in discussing cumulative losses, the FASB did note, in Statement 109.100 (non-authoritative), that the Board considered losses in the context of a three-year period. Although interpretations might vary, we believe a company is in a cumulative loss position for financial reporting purposes when it has a cumulative loss for the latest three years (see Basis for Conclusions of Statement 109 [non-authoritative]). This means that a company with a loss in the current year in excess of income realized in its previous two years would be in a cumulative loss position.
We believe that, to measure cumulative losses for this purpose, a company should use book income and include pretax results from all sources except for the cumulative effect of changes in accounting principles. In other words, pretax results from continuing operations and discontinued operations should be combined to determine whether a company is in a cumulative loss position.
In certain situations, a company may not be in a cumulative loss position in the current year but may expect to be in a cumulative loss position in the near future. We do not believe there is a significant difference between being in a cumulative loss position and expecting to be in one. That is, we believe that both being in a cumulative loss position and expecting to be in one provide significant negative evidence such that projections of future taxable income will rarely be sufficient to substantiate that a deferred tax asset is realizable at a more-likely-than-not level of assurance.
Because recent cumulative losses constitute significant negative evidence, positive evidence of equal or greater significance is needed at a minimum to overcome that negative evidence before a tax benefit is recognized for deductible temporary differences and loss carryforwards based on a projection of future taxable income. In evaluating the positive evidence available (that is, the four sources of taxable income20 ), expectations about future taxable income would rarely be sufficient to overcome the negative evidence of recent cumulative losses, even if they were supported by detailed forecasts and projections. In such cases, expectations about future taxable income are generally overshadowed by a company's historical loss experience in recent years. Estimating future taxable income in such cases often necessitates the prediction of a turnaround or other change in circumstances, which typically cannot meet the objective verification requirement of ASC 740. On the other hand, taxable income available in prior carryback years (which generally would be limited in circumstances where pretax losses were incurred for the last few years), reversals of existing taxable temporary differences and qualifying tax planning strategies generally would represent positive evidence in these cases.
20 See section 6.2, Sources of taxable income, for further discussion of these items.
While we recognize that differences exist in practice with respect to the definition of cumulative losses, ASC 740 is very clear that the FASB specifically rejected using cumulative losses as a bright-line, or “on/off switch” related to valuation allowances. As a result, the determination of whether a company is, or is not, in a cumulative loss position does not, in and of itself, result in a conclusion with respect to the realizability of deferred tax assets. However, ASC 740 also is clear that losses are negative evidence and that consistent with the conclusion reached by the FASB in ASC 740-10-30-21 and ASC 740-10-30-23, a company that is in a cumulative loss position must consider the weight of this significant negative evidence together with the weight of other positive and negative evidence that is available from the four sources of taxable income to determine the realizability of deferred tax assets and that overcoming negative evidence such as cumulative losses in recent years is difficult.
The need for a valuation allowance is assessed by tax component and by tax jurisdiction. That is, realization of a deferred tax asset depends on adequate taxable income in the carryback or carryforward period in the appropriate tax jurisdiction. As a result, positive and negative evidence, including cumulative losses, should also be considered at that level. Therefore, when evaluating all available evidence, we believe the negative evidence from cumulative losses at the consolidated financial statements level would need to be considered when evaluating the realizability of deferred tax assets of a company's subsidiaries (in separate tax jurisdictions).
For example, when a company is in a cumulative loss position on a consolidated basis, the company would consider this negative evidence when evaluating the realizability of deferred tax assets of a subsidiary (in a separate tax jurisdiction) that is relying on projections of future taxable income to realize a deferred tax asset, even if the subsidiary is not in a cumulative loss position. The negative evidence of the consolidated group's cumulative loss may be difficult to overcome when there are intercompany arrangements and transactions that contribute to the subsidiary's profitability (e.g., financing, sales, purchases). In these cases, the results of the consolidated parent are likely a source of negative evidence for the subsidiary. However, if the subsidiary is in a separate tax jurisdiction, has transactions with third parties (e.g., sales) and has a history of generating taxable income without such intercompany transactions, it may be possible for the negative evidence of the parent to be overcome when determining whether a valuation allowance is needed for the subsidiary's deferred taxes. Similarly, if a subsidiary (in a separate tax jurisdiction) is in a cumulative loss position but on a consolidated basis the parent is not, it is possible certain strategies are available (e.g., changing intercompany arrangements) to direct profits of the consolidated entity to the subsidiary in the future (subject to the appropriateness of such actions as valid tax-planning strategies as well as an ability to rely on projections of future taxable income). However, if those strategies create taxable losses at the parent or other subsidiaries (in a separate tax jurisdiction) and those tax benefits cannot be realized, the strategy would not result in the realization of the deferred tax assets of the subsidiary in the cumulative loss position.
(1). Unusual, nonrecurring and noncash charges —
We believe all items, except for changes in accounting principles, should generally be considered as a starting point in evaluating whether a company is in a cumulative loss position. Thus, restructuring charges would not be eliminated from the cumulative losses even though future operating results may be improved due to plant closings or similar reductions in fixed operating costs. Likewise, impairments of goodwill or other assets also would be included in the cumulative loss evaluation even if those items were acquired through the issuance of the company's equity securities. That does not, however, mean that qualitatively all cumulative losses are the same. For example, a company that is in a three-year cumulative loss position due to a loss on the disposal of a discontinued operation in the prior year may be more likely to generate future taxable income than a company in a cumulative loss position as a result of recurring operating losses. A company would need to carefully consider the factors associated with the cumulative loss as part of its evaluation of all available evidence.
(2). Emergence from bankruptcy
We often receive questions regarding the cumulative loss considerations for an entity that emerges from bankruptcy and applies fresh-start accounting pursuant to ASC 852. Generally, we have found that entities emerging from bankruptcy experienced significant financial and operating difficulty immediately before bankruptcy. While the company may have realized substantial improvements in operating results while subject to the bankruptcy court oversight, had certain costs not been set aside during bankruptcy, most companies would have continued to experience losses. As such, the weight of the significant negative evidence of prior losses and the bankruptcy itself must be considered with the other positive and negative evidence available from the four sources of taxable income before concluding on the realizability of the deferred tax assets.
b. Other negative evidence —
As noted in ASC 740-10-30-21, other negative evidence may exist and should be considered when determining the need for, and amount of, a valuation allowance. Although the types of other negative evidence are fairly straightforward, it should be noted that an absence of those other forms of negative evidence is not considered positive evidence as described in ASC 740-10-30-22. For example, if a company has not had net operating loss or tax credit carryforwards expire unused, it does not indicate positive evidence exists of a sufficient quality and quantity to obviate the need for a valuation allowance.
1. Going-concern opinion —
If an auditor modified its opinion to state a substantial doubt exists about an entity's ability to continue as a going concern, we believe, for all practical purposes, projections of future taxable income will not be sufficient to overcome the negative evidence related to the entity's ongoing existence. Accordingly, other sources of taxable income (e.g., reversal of existing taxable temporary differences) would be necessary to conclude that a full valuation allowance was not necessary for deferred tax assets.
2. Carryforwards and other tax attributes that do not expire —
The future realization of deferred tax assets ultimately depends on the existence of sufficient taxable income of the appropriate character in either the carryback or carryforward period under the tax law. In certain tax jurisdictions, operating loss and/or tax credit carryforwards do not expire. For example, US federal NOL carryforwards arising in taxable years ending after 31 December 2017 do not expire (see section 6.4.1, Considerations when NOL carryforwards do not expire or when tax law limits the use of NOL carryforwards, for additional information). In such situations, it is still necessary for a company to evaluate the deferred tax assets for realizability.
It is not appropriate to assume that the carryforward will ultimately be realized simply because the carryforward does not expire or has a long period of carryforward (e.g., 20 years). A valuation allowance would still be necessary if, based on the weight of available evidence, it cannot be determined that it is more likely than not (likelihood of more than 50%) that the deferred tax asset will be realized. Refer to section 6.4.4, Limitations on taxable temporary differences related to indefinite-lived assets as a source of future taxable income, for discussion of whether a deferred tax liability related to an indefinite-lived intangible asset (including tax-deductible goodwill) may be used as a source of income to realize a deferred tax asset relating to a loss carryforward that does not expire.