This article first appeared in the April 2023 edition of The Tax Adviser magazine.
Assessing the need for a valuation allowance
Over the past decade or so, financial reporting under GAAP has become more mechanical or formulaic, with the goal of increasing consistency among financial statement preparers. Yet, professional judgment remains a critical skill in preparing and auditing financial statements, even though the trend in financial reporting may appear to lessen the need for it.
A key part of accounting for income taxes under FASB Accounting Standards Codification (ASC) Topic 740, Income Taxes, that requires significant professional judgment is evaluating the need for a valuation allowance. The valuation allowance reduces a company’s deferred tax assets (DTAs) to the amount more likely than not to be realized. This analysis requires thoroughly evaluating all positive and negative evidence available and includes objective, subjective, and mechanical elements.
A general starting point in the valuation allowance assessment is to look at the company’s three-year cumulative pretax book losses or earnings. Companies that show a strong history of earnings demonstrate positive evidence that a valuation allowance is not needed. Likewise, the guidance in ASC Paragraph 740-10-30-23 states: “A cumulative loss in recent years is a significant piece of negative evidence that is difficult to overcome.” While a cumulative loss is not a bright-line test, a company with pretax losses has a significant piece of negative evidence. While the term “recent years” is not defined, most practitioners define this as the three-year period including the current-year results.
Evaluating cumulative earnings or losses is only one piece of evidence; companies must analyze all negative and positive evidence to determine whether a valuation allowance is needed. The guidance in ASC Paragraph 740-10-30-18 identifies four possible sources of taxable income that may be available under the tax law to support the realization of DTAs:
- Future reversal of existing taxable temporary differences;
- Future taxable income exclusive of reversing temporary differences and carryforwards;
- Taxable income in prior carryback year(s), if carryback is permitted under the tax law; and
- Tax planning strategies.
If one or more sources are sufficient to support realization of a company’s DTAs, the company does not need to consider the remaining sources. In considering the weight of available evidence, the guidance in ASC Paragraph 740-10-30-23 states: “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.”
As discussed below, assessing the need for a valuation allowance requires careful professional judgment.
Impact of private company goodwill alternatives (FASB ASU 2014-02)
In 2014, FASB issued Accounting Standards Update (ASU) No. 2014-02, Intangibles — Goodwill and Other (Topic 350), outlining the private company alternative for goodwill that allows nonpublic companies to elect to amortize goodwill on a straight-line basis over 10 years, or less than 10 years if the company demonstrates that another useful life is more appropriate.
The private company alternative for goodwill significantly reduces the cost and complexity for financial statement preparers. While it also reduces net income due to the expense resulting from the amortization of goodwill, for nonpublic companies making this election, the reduction in net income may not be all that impactful from the perspective of the users of the financial statements. The private company alternative for goodwill also indirectly affects a company’s income tax provision.
Prior to the private company alternative for goodwill, deferred tax liabilities (DTLs) resulting from tax-deductible goodwill were considered indefinite. For companies with a valuation allowance, an indirect effect of adopting the private company alternative was a reduction in the amount of valuation allowance required as a result of goodwill being converted from an indefinite-lived asset to a definite-lived asset. For companies that amortize goodwill, DTLs created by the amortization of goodwill for tax purposes are now considered reversing DTLs and provide a source of income to support the realization of reversing DTAs.
Effect of the TCJA
Several years after FASB issued ASU No. 2014-02, the law known as the Tax Cuts and Jobs Act (TCJA), P.L. 115-97, was enacted. The TCJA modified the net operating loss (NOL) rules, providing that NOLs generated after Jan. 1, 2018, can now be carried forward indefinitely but can offset only 80% of taxable income in the year of utilization. Indefinite-lived DTLs serve as a source of income to support the realization of these NOLs. With certain NOLs now being indefinite, indefinite-lived DTLs have the effect of reducing the amount of valuation allowance required with regard to indefinite-lived DTAs, while the 80% limitation on utilization has resulted in companies needing to carefully schedule the reversal of existing DTLs and DTAs to determine how the limitations under the TCJA impact the amount of realization supported by DTLs. While the scheduling exercise and the evaluation of cumulative losses are mechanical, projecting future taxable income requires significant amounts of professional judgment.
For private companies that have elected the private company alternative for goodwill, careful examination of expected future results is necessary to determine whether a valuation allowance is required. Consider the following example, which illustrates the need to exercise professional judgment: