To determine whether a valuation allowance should be recognized for deferred tax assets under U.S. generally accepted accounting principles, entities need to discern whether it is more likely than not that some or all of their deferred tax assets will not be realized. Subtopic 740-10-30 of the Financial Accounting Standards Board’s Accounting Standards Codification (ASC) addresses this determination and requires consideration to be given to all available evidence, both positive and negative. ASC 740-10-30-23 emphasizes that the weight given to each piece of evidence should be commensurate with the extent to which it can be objectively verified, and specifically notes that a cumulative loss in recent years is a significant piece of negative evidence that is difficult to overcome.
While ASC 740 does not define how to determine whether a cumulative loss in recent years exists, most interpretive guidance generally uses a “three-year” convention. The three-year convention is described as pretax book income/loss from all sources (i.e., including discontinued operations and other comprehensive income or loss) for the current year plus the previous two years, adjusted for certain permanent differences. In addition to adjusting for permanent differences, the only other item that generally should be excluded from the computation of cumulative income/loss is the cumulative effect of a change in accounting principle. However, the impact of profitable discontinued operations and true one-time events should be carefully considered when evaluating the other positive and negative evidence.
The recent pandemic has had a negative financial impact on many industries. This negative impact will likely result in more entities being in a cumulative loss position. Significant judgment is required in considering the positive and negative evidence when determining whether a valuation allowance for deferred tax assets is necessary. As previously noted, the amount of weight given to the evidence must be commensurate with the extent to which it can be objectively verified. Since estimates of future income are inherently subjective, they are given less weight in the valuation allowance assessment than objectively verifiable negative evidence presented by cumulative losses.