11.5 Valuation Allowances

In accordance with the guidance in ASC 740-10 and ASC 805-740, an acquirer recognizes DTAs and DTLs associated with the assets acquired and the liabilities assumed in a business combination. The acquirer also assesses whether a valuation allowance is required against some or all of the acquired DTAs when it is not more likely than not that such DTAs will be realized. This is generally done as part of purchase accounting. The business combination may also cause a change in judgment about the realizability of the acquirer’s DTAs.

Special consideration is required of a reporting entity when it is accounting for changes in a valuation allowance as of or after a business combination under ASC 805-740. The reporting entity should carefully consider the reason for the change in the valuation allowance, the DTAs to which the change in valuation allowance relates (i.e., whether they are the acquiree’s or the acquirer’s), and whether the information that caused the change in judgment existed before the acquisition date.

ASC 805-740

30-1 An acquirer shall measure a deferred tax asset or deferred tax liability arising from the assets acquired and liabilities assumed in a business combination in accordance with Subtopic 740-10. Discounting deferred tax assets or liabilities is prohibited for temporary differences (except for leveraged leases, see Subtopic 842-50) related to business combinations as it is for other temporary differences.

30-2 See Example 1 (paragraph 805-740-55-2) for an illustration of the measurement of deferred tax assets and a related valuation allowance at the date of a nontaxable business combination.

30-3 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 allowance 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]).

35-1 An acquirer may have a valuation allowance for its own deferred tax assets at the time of a business combination. The guidance in this Section addresses measurement of that valuation allowance and the potential need to distinguish the separate pasts of the acquirer and the acquired entity in the measurement of valuation allowances together with expected future results of operations. Guidance on the subsequent measurement of deferred tax assets or liabilities arising from the assets acquired and liabilities assumed in a business combination, and any income tax uncertainties of an acquiree that exist at the acquisition date, or that arise as a result of the acquisition, is provided in Subtopic 740-10.

35-2 Changes in the acquirer’s valuation allowance, if any, that result from the business combination shall reflect any provisions in the tax law that restrict 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.

35-3 Any changes in the acquirer’s valuation allowance shall be accounted for in accordance with paragraph 805-740-30-3. For example, the tax law may limit the use of the acquired entity’s deductible temporary differences and carryforwards to subsequent taxable income of the acquired entity included in a consolidated tax return for the combined entity. In that circumstance, or if the acquired entity will file a separate tax return, the need for a valuation allowance for some portion or all of the acquired entity’s deferred tax assets for deductible temporary differences and carryforwards is assessed based on the acquired entity’s separate past and expected future results of operations.

11.5.1 Accounting for Changes in the Acquirer’s and Acquiree’s Valuation Allowances as of and After the Acquisition Date

The table below summarizes the differences between accounting for changes in the acquiring entity’s valuation allowance and accounting for the acquired entity’s valuation allowances as of and after the acquisition date.

	Changes in Valuation Allowance as a Result of Facts and Circumstances That:
	Existed as of the Acquisition Date	Occurred After the Acquisition Date
Valuation allowance on the acquiring entity’s DTAs that existed as of the acquisition date	Generally, ASC 805-740-35-3 requires that changes in assumptions about the realizability of an acquirer’s valuation allowance as a result of a business combination be recorded separately from business combination accounting. Accordingly, all changes to an acquirer’s valuation allowance as the result of a business combination, whether as of the acquisition date or subsequently, should be recognized in income tax expense (or credited directly to contributed capital [see ASC 740-10-45-20]).
Valuation allowance on the acquired entity’s DTAs that existed as of the acquisition date	Record as part of the business combination (adjustment to goodwill) only if the change occurred in the measurement period and resulted from new information about facts and circumstances that existed as of the acquisition date. If, as a result of the adjustment, goodwill is reduced to zero, any additional amounts should be recognized as a bargain purchase in accordance with ASC 805-30-25-2 through 25-4. All other changes should generally be recorded as an adjustment to income tax expense (see ASC 805-740-45-2).	Generally, record as an adjustment to income tax expense (see ASC 805-740-45-2).

Under ASC 805, a valuation allowance established against acquired DTAs is recorded as part of acquisition accounting (i.e., establishing the valuation allowance would generally result in an increase to goodwill). By contrast, under ASC 805-740-30-3, a change in the acquirer’s valuation allowance as a result of the business combination is recognized as a component of income tax expense (i.e., it is accounted for separately from the business combination). In addition, the impact of a change in a valuation allowance related to acquired DTAs as a result of facts and circumstances that occurred after the acquisition date is recognized as a component of income tax expense separately from the business combination.

Although a change in judgment related to an acquiring entity’s valuation allowance may appear to be linked to the business combination (e.g., the addition of an extra source of income to support realizability of DTAs), the impact should generally be recorded to income tax expense or benefit in the period of the change in judgment. For example, in some tax jurisdictions, tax law permits the use of deductible temporary differences or carryforwards of an acquiring entity to reduce future taxable income if consolidated tax returns are filed after the acquisition. Assume that as a result of a business combination, it becomes more likely than not that an acquiring entity’s preacquisition tax benefits will be realized. ASC 805-740-30-3 requires that changes in assumptions about the realizability of an acquirer’s valuation allowance, as a result of the business combination, be recorded separately from the business combination accounting. If, as of the acquisition date, realization of the acquiring entity’s tax benefits becomes more likely than not, reductions in the acquiring entity’s valuation allowance should be recognized as an income tax benefit (or credited directly to contributed capital — see ASC 740-10-45-20 and related guidance in Sections 6.2.2 and 6.2.3). Similarly, any subsequent changes to the acquiring entity’s valuation allowance will not be recorded as part of acquisition accounting (i.e., no adjustments to goodwill).

11.5.2 Assessing the Need for a Valuation Allowance as of and After the Acquisition Date

It may be complex for a reporting entity to determine whether DTAs — whether those of the acquiree or those of the acquirer — are more likely than not to be realized when the entity undertakes an acquisition. ASC 740-10-30-18 indicates that the future reversal of existing taxable temporary differences is one of four possible sources of taxable income that may be available to an entity for realizing a tax benefit for deductible temporary differences and carryforwards under the tax law. In some cases, acquired DTLs may represent a source of taxable income that supports the realizability of some or all of the benefit of either (1) the acquired DTAs or (2) the acquirer’s DTAs but is not sufficient to support both. In this circumstance, the guidance in ASC 805 and ASC 740 is not clear about whether the acquired DTLs should be first considered a source of taxable income in the evaluation of realizability of the acquired DTAs or the acquirer’s existing DTAs.

There are two acceptable methods that entities can use to determine how the source of taxable income from the future reversal of acquired DTLs should be allocated in the evaluation of the realizability of the acquired DTAs and the acquirer’s existing DTAs. The method an acquirer selects is an accounting policy decision that should be applied consistently. The acquirer should also provide appropriate disclosures, including information about benefits or expenses recognized for changes in its valuation allowance made in accordance with ASC 805-740-50-1.

Method 1: Assess acquired DTAs first — The acquirer first considers the acquired DTLs to be a source of taxable income for realization of the acquired DTAs. ASC 805-20-30-1 states that the “acquirer shall measure the identifiable assets acquired, the liabilities assumed, and any noncontrolling interest in the acquiree at their acquisition-date fair values.” Allocating the source of taxable income from the acquiree’s DTLs first to the realization of the acquiree’s DTAs is consistent with this principle. Any net residual source of taxable income from the acquiree’s DTLs remaining after the acquiree’s DTAs are taken into account would be considered a potential source of taxable income for the realization of the benefit of the acquirer’s existing DTAs. Any change in the acquirer’s valuation allowance is recognized in income tax expense.
Method 2: Assess on the basis of tax law ordering — Allocation of the source of taxable income from the acquiree’s DTLs is based on the tax law in the given jurisdiction. To determine whether the acquiree’s DTAs or the acquirer’s DTAs will be used to reduce taxable income that results from the reversal of the DTLs, the acquirer schedules the reversal of all temporary differences of both the acquirer and the acquiree on the basis of the applicable tax law. If such scheduling does not result in a determination, the acquirer should develop a systematic, rational, and consistent method for scheduling the reversal of the temporary differences. Under this method, a net DTL could be recorded through purchase accounting, and the entity could simultaneously recognize an income tax benefit for the release of the acquirer’s valuation allowance. The net DTL that is reflected in the acquisition accounting will commonly result in an increase of an asset (generally goodwill).

Under this method, it is assumed that the fair value measurement principle is not applied to DTAs and DTLs and that scheduling of the combined group’s DTLs and DTAs is a normal part of that valuation analysis by an acquirer. It is also assumed that immediately after the business combination, the valuation allowance determination is performed by using the combined group’s postacquisition positive and negative evidence (i.e., not solely the acquiree’s positive and negative evidence).

Example 11-26

This example illustrates the application of each method in a valuation allowance assessment.

Assume the following:

AC purchased TC in a nontaxable transaction.
AC will file a consolidated tax return that will include TC.
Before the acquisition, AC has a $1,000 NOL DTA with a $1,000 valuation allowance.
After the application of acquisition accounting, TC has a $600 NOL DTA and a $600 DTL.
Other than the $600 DTL, there are no other sources of taxable income for realizing the benefit of the consolidated group’s DTAs.
In accordance with tax law, the oldest available NOLs must be used first. There are no other limitations on the use of attributes.

The following table shows the years when the NOL carryforwards will expire:

The following table shows the years when the DTL will reverse:

Application of Method 1

TC records a DTA of $600 and a DTL of $600 as part of the acquisition accounting. There is no impact on AC’s deferred tax balances. AC’s final consolidated financial statements will reflect a $1,600 DTA, a $600 DTL, and a $1,000 valuation allowance.

Application of Method 2

Per tax law, AC’s older NOL DTAs must be used first; however, a portion of AC’s NOL DTAs will expire in 20X1 and 20X2 before the full reversal of the DTL. The $300 of taxable income that will result from reversal of the acquired DTL in 20X1 and 20X2 will be allocated as a source of income to support the realizability of AC’s NOL DTA. The $300 of taxable income that will result from reversal of the acquired DTL in 20X3 and 20X4 will be allocated as a source of income to support the realizability of TC’s NOL DTA.

The purchase price allocation for TC will therefore include a $600 DTA, a $600 DTL, and a $300 valuation allowance as part of the acquisition accounting. AC will reverse $300 of valuation allowance and record a corresponding income tax benefit of $300. AC’s final consolidated financial statements will reflect a $1,600 DTA, a $600 DTL, and a $1,000 valuation allowance.

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This publication provides comprehensive guidance; however, it does not address all possible fact patterns, and the guidance is subject to change. Consult a Deloitte & Touche LLP professional regarding your specific issues and questions.