Excerpt from Accounting Standards Codification
2. A company ordinarily might not take, but would take to prevent an operating loss or tax credit carryforward from expiring unused. Actions management undertakes in the normal course of
6.6 Evaluation of positive and negative evidence Excerpt from Accounting Standards Codification Excerpt from Accounting Standards Codification
Income Taxes — Overall Initial Measurement 740-10-30-21
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. A history of operating loss or tax credit carryforwards expiring unused b. Losses expected in early future years (by a presently profitable entity)
c. Unsettled circumstances that, if unfavorably resolved, would adversely affect future operations and profit levels on a continuing basis in future years
d. A carryback, carryforward period that is so brief that 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.
740-10-30-22
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, infrequent, or extraordinary item) is an aberration rather than a continuing condition.
6.6.1 Cumulative losses (updated October 2011)
While not included in the Accounting Standards Codification, the FASB considered, in the Basis for Conclusion of Statement 109 (non-authoritative), whether the criteria for recognizing deferred tax assets should be established at a higher level (such as “probable” or “assured beyond a reasonable doubt”) when there is a cumulative pretax loss for financial reporting for the current and two preceding years (i.e., a three-year cumulative loss). In this regard, the FASB concluded that more restrictive criteria were not necessary because a cumulative loss in recent years is a significant piece of negative evidence that would be difficult to overcome on a more-likely-than-not or any other basis. While the FASB also rejected the use of cumulative losses as a bright line (or “on/off switch”) requiring a valuation allowance,
the FASB did specifically incorporate in ASC 740-10-30-21 that forming a conclusion that a valuation allowance is not needed is difficult when there is significant negative evidence such as cumulative losses in recent years.
ASC 740 does not specifically define “cumulative losses in recent years.” However, in discussing cumulative losses, the FASB did note in Statement 109.100 (non-authoritative) that they considered losses in the context of a three-year period. Although interpretations might vary, we believe a company is in a cumulative loss position for financial reporting purposes when it has a cumulative loss for the latest three years (see Basis for Conclusion of Statement 109 [non-authoritative]). This means that a company with a loss in the current year in excess of income realized in its previous two years would be in a cumulative loss position.
In certain situations a company may not be in a cumulative loss position in the current year but may expect to be in a cumulative loss position in the near future. We do not believe there is a significant difference between being in a cumulative loss position and expecting to be in one. That is, we believe that both being in a cumulative loss position and expecting to be in one are both significant negative evidence such that projections of future taxable income will rarely be sufficient in those instances in order to substantiate that a deferred tax asset is realizable at a more-likely-than-not level of assurance.
In measuring losses for this purpose, we believe a company should base this analysis on book income and include pretax results from all sources except for the cumulative effect of changes in accounting principles.
In other words, pretax results from continuing operations, discontinued operations, and extraordinary items should be combined in determining whether a company is in a cumulative loss position.
Because recent cumulative losses constitute significant negative evidence, positive evidence of equal or greater significance is needed at a minimum to overcome that negative evidence before a tax benefit is recognized for deductible temporary differences and loss carryforwards based on a projection of future taxable income. In evaluating the positive evidence available (that is, the four sources of taxable
income11), expectations as to future taxable income would rarely be sufficient to overcome the negative evidence of recent cumulative losses, even if supported by detailed forecasts and projections. In such cases, expectations about future taxable income are generally overshadowed by a company’s historical loss experience in recent years. Estimating future taxable income in such cases often necessitates the prediction of a turn-around or other change in circumstances, which typically is not susceptible to the objective verification requirement of ASC 740. On the other hand, taxable income available in prior carryback years (which generally would be limited in circumstances where pretax losses were incurred for the last few years), reversals of existing taxable temporary differences, and qualifying tax planning strategies generally would represent positive evidence in these cases.
While we recognize that differences exist in practice with respect to the definition of cumulative losses, ASC 740 is very clear that the FASB specifically rejected using cumulative losses as a bright-line, “on/off switch” related valuation allowances. As a result, the determination of whether a company is, or is not, in a cumulative loss position does not, in itself, result in a conclusion with respect to the realizability of deferred tax assets. However, ASC 740 also is clear in noting that losses are negative evidence and that consistent with the conclusion reached by the FASB in ASC 740-10-30-21 and ASC 740-10-30-23, a company that is in a cumulative loss position must consider the weight of this significant negative evidence together with the weight of other positive and negative evidence that is available from the four sources of taxable income to determine the realizability of deferred tax assets and that overcoming negative evidence such as cumulative losses in recent years is difficult.
The need for a valuation allowance is assessed by tax jurisdiction. That is, realization of a deferred tax asset is dependent on adequate taxable income in the carryback or carryforward period in the
appropriate tax jurisdiction. As a result, positive and negative evidence, including cumulative losses,
11 See Section 6.1, Sources of taxable income, for further discussion of these items.
should also be considered at that level. However, as a source of negative evidence we believe cumulative losses should also be considered at the consolidated financial statements level. For example, when a company has been incurring losses such that on a consolidated basis they are in a cumulative loss position, we would consider the effects of that trend on a subsidiary (in a separate tax jurisdiction) that is relying on projections of future taxable income to realize a deferred tax asset, even if the subsidiary is not in a cumulative loss position. If the subsidiary has intercompany transactions (e.g., financing, sales, purchases, etc.) that contribute to that profitability, the results of the consolidated parent are likely a source of negative evidence for the subsidiary. Similarly if a subsidiary (in a separate tax jurisdiction) is in a cumulative loss position but on a consolidated basis the parent is not, it is possible certain strategies are available (e.g., changing intercompany arrangements) such that the profitability of the consolidated entity may be directed to the subsidiary in the future (subject to the appropriateness of such actions as valid tax planning strategies as well as an ability to rely on projections of future taxable income).
6.6.1.1 Unusual, nonrecurring and noncash charges
We believe all items, except for changes in accounting principles, should generally be considered as a starting point in evaluating whether a company is in a cumulative loss position. Thus, restructuring charges would not be eliminated from the cumulative losses even though future operating results may be improved due to plant closings or similar reductions in fixed operating costs. Likewise, impairments of goodwill or other assets also would be included in the cumulative loss evaluation even if those items were acquired through the issuance of the company’s equity securities. That does not, however, mean that qualitatively all cumulative losses are the same.
6.6.1.2 Emergence from bankruptcy
Several questions have arisen regarding the cumulative loss considerations for an entity that emerges from bankruptcy and applies fresh start accounting pursuant to ASC 852. Generally, we have found that entities emerging from bankruptcy had experienced significant financial and operating difficulty
immediately prior to bankruptcy. While the company may have realized substantial improvements in operating results while subject to the bankruptcy court oversight, had certain costs not been set aside during bankruptcy, most companies would have continued to experience losses. As such, the weight of the significant negative evidence of prior losses and the bankruptcy itself must be considered with the other positive and negative evidence available from the four sources of taxable income before concluding on the realizability of the deferred tax assets.
6.6.2 Going concern opinion
To the extent an auditor has modified its opinion concluding a substantial doubt exists about an entity’s ability to continue as a going concern, we believe, for all practical purposes, projections of future taxable income will not be sufficient to overcome the negative evidence related to the entity’s ongoing existence.
Accordingly, other sources of taxable income would be necessary to conclude that a full valuation allowance was not necessary for deferred tax assets.
6.6.3 Other negative evidence
As noted in ASC 740-10-30-21, other negative evidence may exist and should be considered when determining the need for, and amount of, a valuation allowance. Although the types of other negative evidence are fairly straightforward, it should be noted that an absence of those other forms of negative evidence is not considered positive evidence as described in ASC 740-10-30-22. For example, if a company has not had net operating loss or tax credit carryforwards expire unused, it does not indicate positive evidence exists of a sufficient quality and quantity to obviate the need for a valuation allowance.
6.6.4 Evaluation of operating loss and tax credit carryforwards
Because a deferred tax asset is recognized for all deductible temporary differences and operating loss and tax credit carryforwards, the benefit of a net operating loss for tax purposes and tax credit carryforwards could be recognized before realized if a conclusion is reached that a valuation allowance is not necessary.
In assessing the need for a valuation allowance, any limitations imposed by the tax law for operating loss or tax credit carryforwards must be considered in determining whether it is more-likely-than-not that some portion or all of the deferred tax asset will not be realized. See Section 6.6.5, Limitation of net operating loss carryforwards, for futher discussion of limitations on net operating loss carryforwards.
ASC 740 provides that a deferred tax asset relating to a loss carryforward would not have to be reduced by a valuation allowance if sufficient positive evidence exists to support its recognition.
Illustration 6-7
Assume that a historically profitable company settles a significant lawsuit such that it is in a net operating loss carryforward position for tax purposes. The realization of a tax benefit associated with the net operating loss carryforward would be dependent upon whether future income of a sufficient amount was considered more-likely-than-not.
Assuming objective evidence indicates that such income was considered more likely than not to occur in the carryforward period, then, in the absence of any evidence to the contrary, recognition of the deferred tax asset without a valuation allowance would be appropriate.
However, reaching a conclusion that a valuation allowance is not required would often be difficult when there is negative evidence, such as cumulative losses in recent (i.e., the current and two preceding) years.
ASC 740-10-30-23 requires that the weight given to the potential effect of negative and positive evidence should be commensurate with the extent to which the evidence can be objectively verified. The requirement to weigh positive evidence based on “the extent to which it can be objectively verified” has the effect of severely limiting those situations where deferred tax assets can be realized when a company has incurred recurring pre-tax losses from operations. The following example illustrates realization of a deferred tax asset relating to a loss carryforward and recognition of the related valuation allowance.
Illustration 6-8
Assume a company has the following operating results and temporary differences. Also, assume the company’s effective tax rate is 40% for all years presented.
20X0
to 20X2 20X3 20X4 20X5 20X6
(amounts in thousands)
Pretax financial income (loss) $ 3,000 $ (4,000) $(1,000) $ 1,000 $4,000 Depreciation temporary
difference (400) (100) (100) 200 200
Taxable income (loss) $ 2,600 $ (4,100) $(1,100) $ 1,200 $4,200
Statutory tax rate 40% 40% 40% 40% 40%
Taxes currently payable
(refundable) $ 1,040 $ (1,040)(a) $ — $ —(b) $1,120(c) (a) In 20X3, $2,600 of the operating loss is carried back to 20X0 — 20X2 to reduce taxes paid in those years and a
receivable of $1,040 ($2,600 x 40%) is recorded for the refund. The remaining $1,500 gross NOL ($600 tax effected) is carried forward to future years.
(b) No tax is due because $1,200 of the $2,600 NOL carryforward ($1,500 carryforward from 20X3 plus $1,100 from 20X4) is used to offset the $1,200 taxable income in 20X5.
(c) In 20X6, taxable income of $4,200 is offset by remaining 20X3 loss carryforwards of $1,400 ($300 from 20X3 and
$1,100 from 20X4). Tax payable is $1,120 (or [$4,200-$1,400] x 40%).
Depreciation temporary difference:
20X2 20X3 20X4 20X5 20X6
Book basis $ 1,000 $ 800 $ 600 $ 400 $ 200
Tax basis (600) (300) — — —
Taxable temporary difference $ 400 $ 500 $ 600 $ 400 $ 200 Consider carryback and carryforward periods as sources of taxable income.
Operating loss carryforwards generated in 20X3 and 20X4 would be utilized as follows:
20X3 20X4 20X5 20X6
Beginning of year operating loss
carryforward $ — $ (1,500) $ (2,600) $ (1,400)
Current year loss (4,100) (1,100) — —
Operating loss carryback 2,600 — — —
Utilization of operating loss
carryforward — — 1,200 1,400
End of year operating loss
carryforward $(1,500) $ (2,600) $(1,400) $ —
Assuming at the end of 20X3, 20X4, and 20X5, available positive evidence is not sufficient to overcome the negative evidence of the recent cumulative losses, deferred taxes would be determined as follows:
20X0
to 20X2 20X3 20X4 20X5 20X6
Deferred tax liability $ (160) $ (200) $(240) $(160) $ (80) Deferred tax asset — 600(d) 1,040(e) 560(f) — Allowance for deferred tax
asset — (400)(g) (800)(g) (400)(g) — Net deferred tax liability $ (160) $ — $ — $ — $ (80) (d) NOL carryforward as of 31 December 20X3 ($1,500) at 40%.
(e) NOL carryforward as of 31 December 20X4 ($2,600) at 40%.
(f) NOL carryforward as of 31 December 20X3 ($1,400) at 40%.
(g) A valuation allowance would be recognized for the amount by which the deferred tax asset exceeds the deferred tax liability (the depreciation temporary difference reverses within the carryforward period). Under certain circumstances, the profitable results in 20X5 combined with other positive evidence might be sufficient to offset the negative evidence of the recent cumulative losses and result in the reduction or elimination of the need for a valuation allowance at 31 December 20X6.
Income tax provision:
20X0
to 20X2 20X3 20X4 20X5 20X6
(amounts in thousands)
Current expense (benefit) $1,040 $(1,040) $ — $ — $ 1,120 Deferred expense (benefit) 160 (160) — — 80
Total $1,200 $(1,200) $ — $ — $ 1,200
6.6.5 Limitation of net operating loss carryforwards (updated October 2011 and September 2013)
A change in ownership may limit an entity’s ability to use net operating loss carryforwards and other losses for purposes of determining taxable income before these items expire. Section 382 of the Internal Revenue Code limits the availability of US net operating loss carryforwards and certain built-in losses when there is an ownership change. The determination of whether such a limitation exists may be uncertain (see Chapter 19, Accounting for uncertainty in income taxes).
Under Section 382 an entity is limited to the amount of US net operating loss carryforwards used to offset current and future year income. To the extent that an entity determines that loss carryforwards are limited and mathematically determines that these credits will expire unused, questions arise as to whether the related deferred tax assets should no longer be recognized or whether a valuation allowance should be established for the amount of the deferred tax assets that will expire unused. We believe that either approach is acceptable. See Section 15.2.7, Tax effects of transactions among or with
shareholders (Updated October 2011), for discussion of the intraperiod tax allocation of transactions among or with shareholders that affect tax attributes of the company.
Similarly, several foreign jurisdictions have enacted tax laws that limit utilization of net operating loss carryforwards. While the application of the limitation varies by jurisdiction, the tax laws are often designed and intended to limit an entity’s ability to use net operating loss carryforwards. These limitations may cause a change in judgment about the realization of a deferred tax asset that was previously assumed to be realizable. For example, prior to a law change, an entity may have relied on a future reversal of existing taxable temporary differences of equal or greater amount as a source of taxable income to realize a net operating loss carryforward. However, a limitation on the amount of taxable income that can be offset with net operating loss carryforwards may cause an entity to not be able to realize the deferred tax asset despite sufficient taxable temporary differences in the carryforward period. The effects of changes in tax laws and rates on deferred tax balances (including a related
reevaluation of valuation allowance on deferred tax assets) are included in income from continuing operations for the period that includes the enactment date. See Section 8.1, Changes in tax laws and rates, for further discussion on when to recognize the tax effects related to new tax legislation.
Illustration 6-7
Assume a Hungarian subsidiary has a deferred tax asset related to a net operating loss of $500 and a deferred tax liability of $700 at 20X0. The Hungarian subsidiary previously concluded a valuation allowance was not required on the deferred tax asset relying solely on future taxable income from the anticipated reversal of the deferred tax liability during the carryforward period.
In 20X1, Hungary enacted a tax law change limiting the usage of net operating loss carryforwards to not exceed 50% of taxable income for any particular year. Prior to the change in tax law, only one source of taxable income was necessary to determine that a valuation allowance was not necessary.
Upon the enactment of the limitation to use net operating losses in a particular year, the consideration of whether a valuation allowance is necessary must include the limitation on the use of the NOL. The Hungarian subsidiary should consider the amount of taxable income (from all four sources of taxable income subject to the limitations of relying on such sources under ASC 74012) that is expected in each period of the carryforward. To the extent that the net operating loss carryfoward is not expected to be utilized due to the newly enacted limitation, and after consideration of all four sources of taxable income, the change in the valuation allowance is included in income from continuing operations in the period including the enactment date.
12 The four sources of taxable income to be considered in determining whether a valuation allowance is required include (from least to most subjective) taxable income in prior carryback years, if carryback is permitted under the tax law; future reversals of existing taxable temporary differences (i.e., offset gross deferred tax assets against gross deferred tax liabilities); tax planning strategies; and future taxable income exclusive of reversing temporary differences and carryforwards (See Section 6.1, Sources of taxable income).
Illustration 6-8
Assume similar facts as Illustration 6-7 except the Hungarian subsidiary has a net operating loss deferred tax asset of $500 and a deferred tax liability of $400 prior to the change in tax law.
Assuming no other sources of taxable income, the Hungarian subsidiary would have previously recorded a valuation allowance of $100 ($500 deferred tax asset less $400 of expected reversal of the deferred tax liability within the carryfoward period).
After the change in tax law, the subsidiary believes that the net operating losses are further limited such that only $200 of the deferred tax liability are expected to be a source of taxable income.
Assuming no other sources of taxable income, the Hungarian subsidiary would increase its existing
$100 valuation allowance by $200 ($300 valuation allowance in total). The $200 increase in valuation allowance is recorded in continuing operations in the period including the enactment date. This may result in the deferred tax liabilities being in excess of the deferred tax assets on a gross basis.
$100 valuation allowance by $200 ($300 valuation allowance in total). The $200 increase in valuation allowance is recorded in continuing operations in the period including the enactment date. This may result in the deferred tax liabilities being in excess of the deferred tax assets on a gross basis.