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5.2 Assessing the need for a valuation allowance
Publication date: 31 Dec 2023
us Income taxes guide
A valuation allowance assessment is both subjective and mechanical. Multiple factors that enter into the assessment to make it highly subjective include:
- assessing whether the weight of available evidence supports the recognition of some or all of an entity’s deferred tax assets;
- determining how objectively verifiable an individual piece of evidence is, and thus how much weight should be given to the evidence; and
- establishing the reversal patterns for existing temporary differences.
However, once those determinations have been made, the process of computing the valuation allowance necessary may be quite mechanical. This mechanical process is important and will have an impact when the weight of available evidence suggests that income in applicable future periods will be insufficient to support the realization of all deferred tax assets. In circumstances when a partial valuation allowance is warranted, the valuation allowance required generally must be supported through detailed scheduling of reversals of temporary differences.
The valuation allowance recorded should be based on management’s judgment of what is more-likely-than-not considering all available information, both quantitative and qualitative. An approach in which a valuation allowance is determined by reference to a certain percentage of an entity’s deferred tax assets would not be appropriate.
Ultimately, the realization of deferred tax assets will depend on the existence of future taxable income, sources of which are covered in TX 5.3.
5.2.1 Evidence to be considered
ASC 740-10-30-17 indicates that all available evidence should be considered when assessing the need for a valuation allowance.
All available evidence, both positive and negative, shall be considered to determine whether, based on the weight of that evidence, a valuation allowance for deferred tax assets is needed. Information about an entity’s current financial position and its results of operations for the current and preceding years ordinarily is readily available. That historical information is supplemented by all currently available information about future years. Sometimes, however, historical information may not be available (for example, start-up operations) or it may not be as relevant (for example, if there has been a significant, recent change in circumstances) and special attention is required.
“All available evidence” includes historical information supplemented by all currently available information about future years. For example, a company may have classified a portion of its business as held-for-sale at period end. The impact of the anticipated disposal of this business on the company’s valuation allowance assessment should generally be considered in the period in which the business is classified as held-for-sale. This is because, to classify for held-for-sale accounting, the disposal of the business must be probable. This is a higher level of certainty than the valuation allowance threshold of more-likely-than-not.
Generally, ASC 740 assumes recovery of assets and settlement of liabilities at the amounts reported in the financial statements. This assumption, in the context of a reporting entity’s valuation allowance assessment, could be interpreted to mean that anticipated pretax gains that may arise because the disposal group is expected to be sold for more than book value should not be considered until the disposal group is sold. However, when the anticipated gains are objectively verifiable, we believe they could potentially be considered in a reporting entity’s evaluation of future sources of taxable income (see Example TX 5-9) but judgment would be required.
Many events occurring after year end but before the financial statements are released that provide additional evidence (negative or positive) regarding the likelihood of realization of existing deferred tax assets should be considered when determining whether a valuation allowance is needed.
However, not all subsequent events should factor into determining the need for a current year valuation allowance. For example, the tax effects of a natural disaster or catastrophe, such as an earthquake or a fire, should be recognized in the period in which they occur. In addition, the effects on the valuation allowance assessment of certain fundamental transactions, such as a business combination or an initial public offering, should not be considered until the period in which they occur. ASC 740 also provides specific guidance for the timing of recognition of other events such as changes in tax law or rates which would not be anticipated in the valuation allowance assessment until such change is enacted. Refer to TX 7.3 for guidance on accounting for changes in tax laws and rates.
Anticipating sales or other transactions that are inconsistent with other financial statement assertions should generally be excluded from consideration (e.g., sales of securities classified as held to maturity or sales of long-lived or indefinite-lived assets that are not classified as held for sale).
Management should exercise judgment when financial statements are issued long after the balance sheet date. The longer after the balance sheet date the financial statements are released, the more difficult it becomes to assess whether new information represents a subsequent year event or whether it should be considered as part of the prior period’s valuation allowance assessment. We generally do not believe that the delayed issuance of a set of financial statements should result in a different assessment of whether a valuation allowance is required.
Example TX 5-1 illustrates limitations on the use of hindsight when assessing the need for a valuation allowance as part of a restatement of prior results.
EXAMPLE TX 5-1
Use of hindsight when assessing the need for a valuation allowance as part of a restatement of prior results
Use of hindsight when assessing the need for a valuation allowance as part of a restatement of prior results
Company A is restating its financial statements for the prior three years 20X1 to 20X3 for items unrelated to taxes. Prior to the restatement and the related filing of amended tax returns, Company A was profitable for each of the three years in the restated period. As a result, it had no valuation allowance recorded against any of its existing deferred tax assets. After taking into consideration the pretax accounting entries, Company A now reflects a significant loss for the year-ended December 31, 20X1, which is of sufficient size to put it into a three-year cumulative loss position at December 31, 20X1. On a restated basis, Company A reports a loss for 20X2, but in 20X3, it returned to significant profitability.
At December 31, 20X1, Company A had a post-restatement deferred tax asset relating primarily to net operating losses (NOLs) that will expire. If the financial results at December 31, 20X1 included the restatement items, there would have been significant uncertainty as to whether Company A would return to profitability in future periods.
Can Company A utilize the knowledge of the profitable results in 20X3 as positive evidence in evaluating whether a valuation allowance is considered necessary for the 20X1 restated accounts?
Analysis
No. We generally believe that the “all available evidence” standard of ASC 740-10-30-17 applies to the information that would have been available at the time of the original issuance of the financial statements. Although Company A returned to significant profitability in 20X3, only information available as of the original issuance date of the financial statements should be used in determining the valuation allowance as of the end of 20X1.
Due to the uncertainty of future GAAP income at December 31, 20X1, positive evidence of sufficient weight was not available to overcome the significant negative evidence of cumulative losses at December 31, 20X1.
In determining whether the valuation allowance is still necessary as of December 31, 20X2 and December 31, 20X3, Company A should re-evaluate the need for a valuation allowance based on all evidence that would have been available at the time of the issuance of the original 20X2 and 20X3 financial statements. It is conceivable that Company A, in its restated financial statements, would report a valuation allowance in 20X1 and a reversal of the valuation allowance in 20X3 based on the weight of evidence available at the time the original financial statements were issued—even though both years are within the restatement period.
5.2.2 Weighting of available evidence
ASC 740 requires the application of a “more-likely-than-not” threshold when determining the need for and amount of a valuation allowance.
Reduce deferred tax assets by a valuation allowance if, based on the weight of available evidence, it is more likely than not (a likelihood of more than 50 percent) that some portion or all of the deferred tax assets will not be realized. The valuation allowance shall be sufficient to reduce the deferred tax asset to the amount that is more likely than not to be realized.
ASC 740-10-30-23 prescribes the weighting of evidence, making the recognition of a deferred tax asset for an entity that has exhibited cumulative losses in recent years difficult.
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.
ASC 740 prescribes the manner in which available evidence should be weighted. What has already occurred (and thus can be objectively verified) carries more weight than what may occur (e.g., projections of future income, which are not typically objectively verifiable). In assessing the need for a valuation allowance, each piece of evidence should be evaluated in light of the extent to which it is objectively verifiable and should be weighted accordingly.
ASC 740’s more-likely-than-not threshold for recognition of a valuation allowance is arguably a lower asset impairment threshold than other asset impairment thresholds within the US GAAP framework. For example, when evaluating accounts receivable, an impairment loss should not be recognized until it is probable that an asset has been impaired and the amount of the loss can be reasonably estimated. “Probable” in that accounting framework is a higher threshold than the more-likely-than-not threshold. As defined in ASC 740-10-30-5, more-likely-than-not is a likelihood of more than 50%, where in practice, 75% is often used as a threshold for “probable.” Therefore, despite using the same information about the results of future operations, inconsistent results may arise when an entity performs an asset impairment analysis versus its valuation allowance assessment. It is not uncommon for an entity to record a valuation allowance against its net deferred tax assets while other assets (e.g., fixed assets or goodwill) are not impaired.
Partial valuation allowance
The weight of the available evidence may in some situations indicate that only a portion of a company’s deferred tax assets will be realized, resulting in the need to record a partial valuation allowance. For example, this can occur when deferred tax assets have attributes with a limited window of use or require income of a certain character, such as a foreign tax credit.
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.
A company’s assessment of the available evidence may cause it to record a partial valuation allowance or release a portion of a full valuation allowance that was previously recorded. In a subsequent period, the facts and circumstances may change, leading the company to conclude that the amount of valuation allowance needs to change. This ongoing reassessment requires significant judgment, especially since changes in the valuation allowance cause volatility in the company’s effective tax rate. Given the inherently imprecise nature of forecasts of future taxable income, partial valuation allowances should generally be tied to objective information about specific deferred tax assets.
5.2.3 Character of income or loss
Reporting entities must consider the character of income (for example, “ordinary” versus “capital,” “domestic” versus “foreign”) when considering whether a valuation allowance for deferred tax assets may be necessary. In the US, for example, capital loss carryforwards may only be utilized against capital gains. If a reporting entity does not have sufficient positive evidence to indicate that capital gains will be generated during the lifetime of the capital loss carryforward such that the carryforward would be realized, a valuation allowance would be necessary. This is true even if the reporting entity generates ordinary income.
5.2.4 Assessing positive and negative evidence
ASC 740-10-30-17 requires reporting entities to consider both positive and negative evidence, keeping in mind two previous concepts discussed in TX 5.2.1 and TX 5.2.2: evidence to be considered and weighting of available evidence.
Determining whether positive evidence outweighs negative evidence is often an area of significant judgment. Reporting entities start their valuation allowance assessment by understanding the positive and negative evidence and the weight it carries (i.e., where it is on the sliding scale of being objectively verifiable).
5.2.4.1 Cumulative losses and other negative evidence
ASC 740-10-30-21 provides examples of negative evidence and indicates that it is difficult to avoid a valuation allowance when there is negative evidence such as cumulative losses in recent years. Other forms of negative evidence to be considered may include recent downward trends in a company’s results and anticipated cumulative losses in the near future.
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 history of operating loss or tax credit carryforwards expiring unused
- Losses expected in early future years (by a presently profitable entity)
- Unsettled circumstances that, if unfavorably resolved, would adversely affect future operations and profit levels on a continuing basis in future years
- 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.
Of the negative evidence cited, “cumulative losses in recent years” is probably the most frequent to be considered. ASC 740 does not define this term. Generally, we believe that the guideline—not a “bright line” but a starting point—should be aggregate pretax results adjusted for permanent items (e.g., nondeductible goodwill impairments) for three years (the current and the two preceding years). The three-year timeframe associated with the cumulative loss assessment may have arisen from past discussion in FAS 109’s Basis for Conclusions. However, there is no authoritative guidance requiring a three-year assessment. That said, three years generally seems to be a long enough period to not be overly influenced by one-time events, but not so long that it would be irrelevant as a starting point for gauging the future. Further, the three-year period is not only a retrospective assessment. We believe it is appropriate to conclude that there are cumulative losses in situations in which an entity is projecting a loss within a year that will put it in a three-year cumulative loss position.
In addition to pretax results adjusted for permanent items, cumulative income or loss would include discontinued operations and other comprehensive income items. The only item that should be excluded from the determination of cumulative losses is the cumulative effect of accounting changes. While some of these items may not be indicative of future results, they are part of total historical results, and similar types of items may occur in future years.
Judgment is necessary to determine the weight given to the results of the cumulative period. Although having a cumulative loss is a significant piece of negative evidence, it does not automatically mean a valuation allowance is necessary; likewise, having cumulative income does not automatically mean a valuation allowance is not needed. As discussed in TX 5.2.2, the weight given to the potential effect of negative and positive evidence should be commensurate with the extent to which it can be objectively verified. Because a cumulative loss in recent years is a significant piece of negative evidence that is difficult to overcome, an entity would need objective positive evidence of sufficient quality and quantity to support a conclusion that, based on the weight of all available evidence, a valuation allowance is not needed. Positive evidence to be considered could include the fact that past losses were clearly tied to one-time, nonrecurring items, or the fact that the company’s earnings are trending positively and they have returned to profitability in recent periods. See TX 5.2.4.3 for further discussion of positive evidence.
If an entity has cumulative losses in recent years, but has very recently returned to profitability, it must consider whether the evidence of recent earnings carries sufficient weight to overcome the weight of existing significant negative evidence. It must also consider whether the level of uncertainty about future operations allows a conclusion that the entity has indeed returned to sustainable profitability.
Example TX 5-2 presents scenarios that are solely intended to illustrate that three years of cumulative losses is not a "bright line" test and that additional analysis of the specific facts and circumstances and significant judgment are required to determine whether a valuation allowance is necessary. These scenarios are for illustrative purposes only and do not include all of the information that may be necessary to form a conclusion regarding the need for a valuation allowance.
EXAMPLE TX 5-2
Cumulative loss in recent years
Cumulative loss in recent years
At the quarter ended September 30, 20X2, Companies A, B, and C are assessing whether the valuation allowances previously recorded on their respective DTAs are needed or should be reversed. None of the companies has any tax-planning strategies available. Each of the companies’ income (loss) in 20X1 includes a $0.6 million nonrecurring charge for a securities class-action legal settlement. The only deferred tax assets the companies have recorded are related to indefinite-lived NOLs.
The following summarizes pretax income (loss) for each of the three companies:
Year ended |
Pretax income (loss) (in millions) |
||
|---|---|---|---|
Company A |
Company B |
Company C |
|
December 31, 20X0 |
($2.0) |
($1.5) |
$2.0 |
December 31, 20X1 |
($0.5) |
($1.0) |
($1.0) |
Projected December 31, 20X2 |
($1.5) |
$1.5 |
($0.5) |
Projected 3-year cumulative income (loss) as of December 31, 20X2 |
($4.0) |
($1.0) |
$0.5 |
Projected December 31, 20X3 |
$1.5-$2.0 |
$1.5-$2.0 |
($1.5)-($2.0) |
What are some of the factors each company should consider when determining whether to retain its valuation allowance at the quarter ended September 30, 20X2?
Analysis
Company A — Three-year cumulative loss; income is projected in the following year
Company A is projecting a cumulative three-year loss of $4.0 million for the period ending December 31, 20X2. Company A expects to incur losses in the fourth quarter of 20X2 and in each of the first three quarters in 20X3 with significant income expected in the fourth quarter of 20X3 that Company A expects will result in overall income for 20X3. Despite the fact that Company A expects to earn income in 20X3, the valuation allowance may continue to be necessary at September 30, 20X2 due to the following:
- Three years of cumulative losses is considered significant negative evidence that is difficult to overcome.
- Although Company A expects income in 20X3, Company A expects continued losses in the fourth quarter of 20X2 and during each of the first three quarters in 20X3.
- Given that Company A incurred net losses in each of the last two years and expects a loss for the full year ending December 31, 20X2, it will be difficult for Company A to assert that there is enough objectively verifiable evidence of future earnings to outweigh the historical negative evidence.
- Even if the $0.6 million nonrecurring charge for the legal settlement in 20X1 is excluded, Company A would continue to be in a three-year cumulative loss position as of December 31, 20X2.
Company B — Three-year cumulative loss; income in the most recent year and income projected in the following year
From an earnings perspective, Company B has been improving each year. Company B is projecting a three-year cumulative loss of $1.0 million as of December 31, 20X2, however, it recorded income of $0.9 million through the third quarter of 20X2, with an additional $0.6M projected in the fourth quarter, resulting in a projected $1.5 million of income for 20X2. Based on the most recent results, Company B is also projecting income for 20X3. Therefore, it would appear that the valuation allowance recorded by Company B may not be necessary due to the following:
- Company B has continuously improved its results over the past three years and has turned to profitability in 20X2.
- Company B has generated income through the third quarter of 20X2 (i.e., the most recent period) and is projecting income for the fourth quarter of 20X2 and for the full year ending December 31, 20X3.
Company C — Three-year cumulative income; loss projected in the following year
From an earnings perspective, Company C has been trending negatively. Company C previously recorded a valuation allowance despite its cumulative income position due to uncertainty in its forecast and other negative evidence. While Company C is not projected to have a three-year cumulative loss as of December 31, 20X2, Company C has projected a loss in the following year, 20X3, that would result in a three-year cumulative loss of $1.0 million to $1.5 million as of December 31, 20X3. Therefore, it would appear that the valuation allowance recorded in a prior period may continue to be necessary due to the following:
- Company C has incurred net losses in two of the last three years (even excluding the $0.6 million nonrecurring charge for the legal settlement in 20X1).
- Company C is projecting a loss in 20X3 and, based on its projection, will have a three-year cumulative loss as of December 31, 20X3.
When considering cumulative losses, it may be necessary to segregate earnings (losses) subject to capital gains rules from those subject to taxes at ordinary rates. This concept is illustrated in Example TX 5-3.
EXAMPLE TX 5-3
Evaluating the need for a valuation allowance on deferred tax assets that are capital in nature
Evaluating the need for a valuation allowance on deferred tax assets that are capital in nature
Corp X has a history of profitable operations and is projecting continued profitability. Consequently, Corp X determined that no valuation allowance was necessary for its deferred tax assets in prior periods. However, in the current year, Corp X generated unrealized and realized losses on its portfolio of equity securities.
As of the end of the current year, Corp X has recorded a deferred tax asset for (1) accumulated capital loss carryforwards, (2) net unrealized losses on equity securities that, if sold, would result in additional capital losses and (3) temporary differences (for example, reserves) subject to ordinary income tax rates. Under the tax law, Corp X can only utilize capital losses to offset realized capital gains. A net capital loss in a particular year may be carried back 3 years and forward 5 years.
On the basis of total income, Corp X is not in a cumulative loss position. Although Corp X has generated capital gains income in the past, the realized and unrealized losses generated in the current year that are capital in nature were significant enough to put Corp X into a cumulative loss position related to its assets that are capital in nature. Corp X expects to generate capital gains in the future; however, management realizes that the assessment of whether or when such gains would occur is inherently subjective in nature.
Corp X does not have any other sources of capital gains income (e.g., tax-planning strategies or carryback availability).
Should Corp X record a valuation allowance for its deferred tax assets that are capital in nature?
Analysis
Yes. A full valuation allowance would be required on its deferred tax assets that are capital in nature. Corp X must assess the realizability of these deferred tax assets separately from the deferred tax assets that are ordinary in nature. Corp X has incurred cumulative losses related to its assets that are capital in nature. As discussed in ASC 740-10-30-21, cumulative losses in recent years represent negative evidence that is difficult to overcome. As a result, objective positive evidence is needed to overcome the significant negative evidence of the cumulative losses. Expectations about the future are inherently subjective, particularly when those expectations depend on future market appreciation, and, therefore, they generally will not be sufficient to overcome negative evidence that includes cumulative losses in recent years. Corp X would not be able to rely on its ability to generate capital gains in the future given the significant capital losses generated in the current year, including the unrealized losses (which gave rise to cumulative losses of a capital nature) and, therefore, must look to other sources of capital gains income (e.g., tax-planning strategies or carryback availability) which are not available.
5.2.4.2 Going concern uncertainty
ASC 205-40, Presentation of Financial Statements—Going Concern, requires management to assess the reporting entity’s ability to continue as a going concern. When management concludes that substantial doubt exists regarding an entity’s ability to continue as a going concern, that conclusion would constitute significant negative evidence under ASC 740 that may result in a valuation allowance for all deferred tax assets that are not assured of realization by either (1) carryback to prior tax years or (2) reversals of existing taxable temporary differences. There may be some limited circumstances when the immediate cause for the going concern uncertainty is not directly related to the entity’s operations, and, absent the matter that led to the uncertainty, the entity would expect to continue generating operating and taxable profits. In these limited circumstances, the company may still be able to support realization of its deferred tax assets.
5.2.4.3 Positive evidence
The existence (or absence) of cumulative losses is only one piece of evidence that should be considered in assessing the need for a valuation allowance. While ASC 740-10-30-21 indicates that it will be difficult for positive evidence to overcome the types of negative evidence cited, ASC 740-10-30-22 gives examples of positive evidence that should be considered.
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.
It is important to note that the examples of positive evidence require deeper consideration—i.e., they do not automatically overcome negative evidence. For example, a mere backlog of orders is not sufficient on its own. In addition to being able to evidence a backlog, management must be able to objectively support that the existing backlog of orders will be profitable and accretive to earnings.
Likewise, management’s belief that the tax assets will be realized is not by itself sufficient, objective positive evidence to overcome objective negative evidence, such as recent losses. Indeed, management may conclude that, while it believes the deferred tax assets will be realized, the weight of objective evidence requires a valuation allowance. In these circumstances, public entities should be mindful that the SEC does not allow assertions (stated or implied) in the forepart of the prospectus for a public offering or a periodic report (e.g., Form 10-K) that are inconsistent with the assumptions used in the preparation of the financial statements.
Illustrative examples of positive evidence
The following examples illustrate when positive evidence may outweigh significant negative evidence so that no, or only a partial, valuation allowance is necessary. Each situation is based on specific facts and circumstances. Similar situations may not necessarily result in the same conclusions.
- An entity underwent a leveraged buyout (LBO) and incurred a large amount of debt as a result of that transaction. For several years after the LBO, the entity incurred substantial losses. Without the interest expense on the LBO-related debt, however, the entity would have been profitable.
Recently, the entity had an initial public offering (IPO) of equity securities. The proceeds of the IPO were used to completely pay off the LBO debt.
After the IPO and the related payoff of the LBO debt, the entity concluded that future income would preclude the need for a valuation allowance for its NOL carryforward deferred tax asset.
This situation demonstrates the concept of “earnings from core operations” (see TX 5.7.3.1). Absent the interest expense from the LBO, the company consistently demonstrated the ability to operate at a profit. While the company still had to overcome the significant negative evidence that resulted from cumulative losses in recent years, the company’s ability to demonstrate an expectation of objectively verifiable earnings from core operations following the debt payoff were sufficient to overcome the cumulative loss caused by the LBO interest expense.
In contrast, if the entity was incurring significant losses as a result of interest on LBO-related debt, but planned to undergo an IPO in the future, the uncertainty regarding the entity’s ability to carry out an IPO would likely lead to a conclusion that a full valuation allowance was appropriate.
- During the past five years, a bank incurred substantial losses as a direct result of commercial real estate and lesser-developed-country (LDC) loans. The bank has fully reserved these problem loans and has not originated any new commercial real estate or LDC loans. The bank’s core businesses, which are primarily consumer and non-real estate commercial lending, historically have been, and continue to be, very profitable.
Management forecasts that, based on historical trends, earnings from its core businesses will, over the next five years, be more than sufficient to recover the losses resulting from the old commercial real estate and LDC loans. Accordingly, it was concluded that a valuation allowance was not necessary for the bank’s deferred tax assets.
In this fact pattern, the bank had demonstrated the ability to be profitable in what it considered to be its core businesses. Once it concluded that it was going to cease originating commercial real estate and LDC loans (and the bank had fully reserved problem loans), the available evidence supported recognition of the deferred tax assets. However, exiting unprofitable businesses does not necessarily ensure that the ongoing entity will be profitable. In some cases, the losses in certain lines of business are indicative of challenges in the company’s broader business model. In other cases, costs associated with those unprofitable businesses may need to be absorbed by the remaining businesses, hindering the historically profitable businesses’ abilities to continue to be profitable. Careful analysis is necessary to determine whether exiting an unprofitable business is sufficient to overcome the losses incurred in recent years.
- An entity had three separate and distinct lines of business. Historically, two of the lines have been, and continue to be, profitable. The third line incurred substantial losses that led to an NOL carryforward on the entity’s consolidated tax return. The entity recently discontinued its unprofitable line and sold the related assets.
The historical profit levels of the continuing operations were such that the entity could realize the NOL in approximately eight years. Because this was well within the NOL carryforward period in the applicable tax jurisdiction, it was concluded that a valuation allowance was not necessary for the entity’s NOL carryforward and other deferred tax assets.
As in the bank example, the mere exiting of a business often does not, in and of itself, ensure future profitable operations. In this case, the company had a clear track record of profitable results in the other lines of business and could demonstrate realization within the carryforward period after considering all of the impacts of the discontinued business. This was considered sufficient positive evidence.
- A company had significant losses in the first two years of operations due to substantial start-up costs and marketing expenses. During year three, the company incurred losses in the first three quarters and income in the last quarter that resulted in a near breakeven year. In year four, although the entity reported increasing levels of income in each quarter, it was still in a three-year cumulative loss position at the end of its fiscal year due to the significant start-up costs and marketing expenses incurred during the first two years of operations. At the end of year four, management’s projections show continued profitability with significant growth going forward. Based on the income recorded in year four (the most recent period), the NOL carryforwards were expected to be utilized well in advance of their expiration dates when the income level forecasted in future years was held consistent with year four and excluded any expected growth in years five and beyond.
Notwithstanding the cumulative loss evidence, as a result of the company’s demonstrated profitability, it was concluded that no valuation allowance is necessary. Depending on the facts and circumstances, other factors such as what caused the losses and when the losses occurred in the three-year period may impact the assessment and conclusion.
5.2.5 Changes in judgment
Determining the need for a valuation allowance is inherently dependent, to some extent, on management judgment. Such judgments may change from period to period. However, when those judgments change, there should be clear, explainable reasons. In assessing changes in the valuation allowance, it is important to consider the basis for amounts previously provided and how new qualitative and quantitative information modifies previous judgments. For example, management should consider whether the results for the current year provide additional insights as to the recoverability of deferred tax assets or as to management’s ability to forecast future results.
The amount of deferred tax assets, net of the valuation allowance, and the amount of change in the valuation allowance in the current year should make sense considering the prior year’s assessment, current year’s earnings, and other available evidence. In general, if adjustments are made in the first quarter, the entity should be able to explain the change from the preceding year-end. Based on the short time period between issuance of an entity’s year-end financial statements and release of its first-quarter Form 10-Q, changes in judgment during this period would be expected to be relatively uncommon and generally would result from a specific, significant event or change in facts and circumstances that could not have been foreseen.
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