The impact on the acquiring company’s deferred tax assets and liabilities caused by an acquisition is recorded in the acquiring company’s financial statements outside of acquisition accounting. Such impact is not a part of the fair value of the assets acquired and liabilities assumed.
For example, in jurisdictions with a graduated tax rate structure, the expected post-combination results of the company may cause a change in the tax rate expected to be applicable when the deferred tax assets and liabilities reverse. The impact on the acquiring company’s deferred tax assets and liabilities is recorded as a change in tax rates and reflected in earnings.
Additionally, the acquirer’s financial statements may have included a valuation allowance before the transaction for its deductible differences or loss carryforwards and other credits. After considering the transaction, the projected combined results, and available taxable temporary differences from the acquired business, the acquirer may be able to release all or part of its valuation allowance. While this adjustment is a result of the acquisition, ASC 805-740-30-3
requires that the benefits be recognized in income or equity, as applicable, and not as a component of acquisition accounting. This benefit is related to the acquirer’s existing assets and should not be considered in the determination of the fair values of the assets acquired and liabilities assumed.
The tax law in some tax jurisdictions may permit the future use of either of the combining entities’ deductible temporary differences or carryforwards to reduce taxable income or taxes payable attributable to the other entity after the business combination. If the combined entity expects to file a consolidated tax return, an acquirer may determine that as a result of the business combination its valuation for its deferred tax assets should be changed. For example, the acquirer may be able to utilize the benefit of its tax operating loss carryforwards against the future taxable profit of the acquiree. In such cases, the acquirer reduces its valuation allowances based on the weight of available evidence. However, that reduction does not enter into the accounting for the business combination but is recognized as an income tax benefit (or credited directly to contributed capital [see paragraph 740-10-45-20]).
Acquired deferred tax liabilities could be a source of income to support recognition of acquired deferred tax assets or the acquirer’s existing deferred tax assets, or both. Accordingly, in circumstances in which some but not all of the combined deferred tax assets are supported by acquired deferred tax liabilities, the acquirer will need to determine which balances are being supported. We believe there are two acceptable accounting policies. One policy is to consider the recoverability of deferred tax assets acquired in the acquisition before considering the recoverability of the acquirer’s existing deferred tax assets. Another policy is to consider relevant tax law ordering rules for utilization of tax assets to determine whether the acquired or pre-existing deferred tax assets are considered realizable.
Example TX 10-12 illustrates the application of the alternative accounting policies on a valuation allowance assessment in acquisition accounting.
EXAMPLE TX 10-12
Accounting policy for considering whether acquired deferred tax liabilities support realization of acquired or acquirer’s deferred tax assets
Company X and Company Y each have $2,000 of deferred tax assets related to net operating loss (NOL) carryforwards generated in the last four years. Other deferred tax assets and liabilities are de minimis. Company X has historically maintained a valuation allowance against its deferred tax assets. In the current period, Company X acquires the shares of Company Y in a nontaxable transaction and the combined business will file a consolidated tax return. As part of the acquisition, deferred tax liabilities of $1,500 related to Company Y are recorded. Although the earnings of the combined entity are not objectively verifiable, the acquired deferred tax liabilities will reverse prior to any NOL expirations and are, therefore, a source of future taxable income that can support the realization of deferred tax assets.
There are no tax law limitations on future realization of the NOL carryforwards. Consequently, Company X determines it needs a valuation allowance of $2,500 (combined deferred tax assets of $4,000 less reversing deferred tax liabilities of $1,500).
In Company X's financial statements, which deferred tax assets (i.e., acquirer’s or acquiree’s) are supported by the deferred tax liabilities recorded upon acquisition of Company Y?
Deferred taxes are recorded in acquisition accounting for the acquired entity’s temporary differences and operating loss/credit carryforwards. However, any changes in the acquirer’s deferred taxes as a result of a business combination should be recorded currently in income.
In this fact pattern, we believe there are two alternative methods to account for the benefit that can be recognized in Company X’s financial statements:
View A—The deferred tax liabilities should first be considered as a source of taxable income in relation to the acquired company’s deferred tax assets, with any residual amount applied to the acquirer’s deferred tax assets. This view is premised on the sequence of events, starting with the acquisition, followed by the consideration of impacts on the acquirer. In this example, a $500 valuation allowance would be recorded in acquisition accounting (i.e., $1,500 of the $2,000 acquired deferred tax assets are expected to be realized), and there would be no recognition of the acquirer’s pre-existing deferred tax assets. The existing valuation allowance against the acquirer’s deferred tax assets ($2,000) would not change.
View B—Realization of the deferred tax assets should be based on underlying tax law ordering for the jurisdiction (e.g., looking first to older NOLs if that is consistent with the tax law in the relevant jurisdiction). The objective would be to determine the reversal pattern of tax attributes and deductible temporary differences under the tax law. However, when the order in which tax attributes and deductible temporary differences will be used is not determinable, the entity should develop a systematic, rational, and consistent methodology for allocating the benefit resulting from the deferred tax liabilities.
Either view is acceptable as an accounting policy election to be applied consistently. Appropriate financial statement disclosure should be made, including specific disclosure of any benefits or expenses recognized for changes in the acquirer’s valuation allowance.