Valuation Allowances and Three-Year Earnings History: Are We Asking the Right Questions?

Few accounting judgments can have a greater impact on reported earnings, and yet be more dependent on uncertainty, than the assessment of a valuation allowance.

Tough questions are answered more easily when frameworks, benchmarks and tests provide a clear path to a conclusion. Yet some of the most important accounting issues arise in areas where the guidance is intentionally less precise and requires thoughtful consideration of the facts and circumstances. One of the clearest examples exists within the determination of whether the realization of deferred tax assets meets the more likely than not standard under ASC 740.

When a Helpful Tool Becomes a Rule

The accounting standard guidance on valuation allowances can be vague and broad. Instead of adhering to strictly defined rules, the standards require companies to evaluate the positive and negative evidence in determining whether their deferred tax assets are more likely than not to be realized.
The standards provide a general rule that a cumulative loss in recent years provides significant negative evidence that is difficult to overcome. With that, most tax professionals are familiar with the three-year cumulative loss analysis being the default starting point in valuation allowance discussions. This can be a practical and effective way to identify companies that may face challenges generating future taxable income. This can lead to a hyper-focus on the three-year earnings history as the linchpin in determining whether a valuation allowance is necessary, as it provides certainty without compromise and a standardized approach.

The key issue here is to understand that the FASB designed the rules so that the history of recent losses is not a litmus test for the assessment of a valuation allowance. It is vitally important to remember that accounting standards ultimately focus on the likelihood of realizing deferred tax assets, not on whether a company passes or fails a single historical test. The overemphasis on a three-year cumulative income or loss history could also overlook deferred tax assets that need to be evaluated for income of a specific character, such as disallowed capital losses and interest deductions that create specifically limited tax attributes.

Business realities are often more complex than a three-year snapshot. Acquisitions, restructurings, investment activities, micro- and macro-economic issues and other events can materially affect reported earnings and create uncertainty about future results.

In those situations, does a cumulative loss necessarily indicate a diminished ability to realize deferred tax assets? Or is it simply reflecting an accounting outcome that is disconnected from the expectation of having future taxes due? The answers are not always obvious, which means it’s important to ask the right questions.

Questions to Consider When Evaluating a Valuation Allowance

Companies that evaluate all of the evidence, both positive and negative, and recognize that evidence that can be objectively verified is more heavily weighted than evidence that is subjective, will typically encounter the least amount of auditor resistance on their valuation allowance position. Certainly, auditors may not be amenable to all of the following items when auditing a company’s position on its deferred tax assets. However, management should understand that the following issues could aid the support and documentation necessary when asserting the need, or lack thereof, for a valuation allowance. Among the questions to consider are:

Final Thoughts

While the three-year earnings history may provide a useful starting point, it should not be viewed as a substitute for a comprehensive evaluation of all available evidence. Companies should develop a well-supported analysis that considers the specific facts and circumstances affecting the realizability of their deferred tax assets and thoroughly documents the basis for their conclusions.

Withum has a dedicated team of skilled tax professionals who have experience guiding companies through the many intricacies and challenges when establishing, releasing or maintaining valuation allowances.