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Year-End Assessment of Valuation Allowances – 3 Things to Consider

U.S. GAAP requires companies to reduce deferred tax assets to the amounts that are more likely than not to be realized. ASC 740-10-30-17 requires companies to assess realizability of deferred tax assets based on “all available evidence, both positive and negative.”

As calendar companies begin preparing year-end financial statements, here are three things to consider when analyzing deferred tax assets and valuation allowances.

1. Cumulative Book Losses

While there is no bright line, mechanical test to rely on when considering the need for a valuation allowance, recent cumulative book losses are a significant piece of negative evidence with respect to realizability of deferred tax assets. ASC 740-10-30-23 states: “A cumulative loss in recent years is a significant piece of negative evidence that is difficult to overcome.” Book losses are verifiable and, as such, should be given more weight. ASC 740-10-30-23 emphasizes, “..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.” Recent cumulative book losses are not defined in the guidance but in practice, practitioners generally agree that a three-year period including current period results is appropriate.

2. Sources of Income

ASC 740 identifies four possible sources of income when considering the realizability of deferred tax assets:

• Carryback of deferred tax assets to offset prior year taxable income as permitted by law
  Certain deferred tax assets, such as net operating losses or capital losses,  may be realized by carrying them back to offset taxable income from a prior period as permitted by law.

• Future reversals of taxable temporary differences
  This would include existing deferred tax liabilities that would offset deferred tax assets as they reverse over time. Careful consideration should be given to deferred tax liabilities associated with indefinite-lived assets. These are only considered sources of income for deferred tax assets that are indefinite in nature.

• Tax planning strategies
  Strategies that initiate or accelerate the realization of deferred tax assets can be considered a source of income. These strategies should be prudent and ones that management would execute in order to prevent the loss of a deferred tax asset. These would also be strategies that the company would not ordinarily undertake.

• Future taxable income (not including reversing taxable temporary differences and carryforwards)
  This is the least objective of the four sources of possible income that can be used to substantiate the realization of deferred tax assets. The use of this future taxable income may not be considered when a company has cumulative book losses. Considerable judgment is involved in projections and the projections need to be consistent with historical results and with other projections used in the financial statements.

3. Required Disclosures

US GAAP requires certain disclosures related to valuation allowances. For example, for each period that companies present a balance sheet, both the total valuation allowance and net change must be disclosed. Public companies should consider adding additional informative disclosures around the realizability of deferred tax assets when there is a valuation allowance, with a particular focus on prospective changes in the valuation allowance.

How Centri Can Help

Valuation allowances are inherently complex, given the subjectivity and judgment surrounding them. Management should be prepared to substantiate their positions with documented analysis supporting their conclusions. At Centri, our Tax experts are here to guide you through your tax needs. We’ll support your team to ensure your business meets the latest requirements and is executing the right strategy to minimize its tax liabilities. Contact us to learn more.