5.2 Basic Principles of Valuation Allowances

ASC 740-10

30-16 As established in paragraph 740-10-30-2(b), there is a basic requirement to reduce the measurement of deferred tax assets not expected to be realized. An entity shall evaluate the need for a valuation allowance on a deferred tax asset related to available-for-sale debt securities in combination with the entity’s other deferred tax assets.

30-17 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.

30-18 Future realization of the tax benefit of an existing deductible temporary difference or carryforward ultimately depends on the existence of sufficient taxable income of the appropriate character (for example, ordinary income or capital gain) within the carryback, carryforward period available under the tax law. The following four possible sources of taxable income may be available under the tax law to realize a tax benefit for deductible temporary differences and carryforwards:

Future reversals of existing taxable temporary differences
Future taxable income exclusive of reversing temporary differences and carryforwards
Taxable income in prior carryback year(s) if carryback is permitted under the tax law
Tax-planning strategies (see paragraph 740-10-30-19) that would, if necessary, be implemented to, for example:
1. Accelerate taxable amounts to utilize expiring carryforwards
2. Change the character of taxable or deductible amounts from ordinary income or loss to capital gain or loss
3. Switch from tax-exempt to taxable investments.

Evidence available about each of those possible sources of taxable income will vary for different tax jurisdictions and, possibly, from year to year. To the extent evidence about one or more sources of taxable income is sufficient to support a conclusion that a valuation allowance is not necessary, other sources need not be considered. Consideration of each source is required, however, to determine the amount of the valuation allowance that is recognized for deferred tax assets.

30-19 In some circumstances, there are actions (including elections for tax purposes) that:

Are prudent and feasible
An entity ordinarily might not take, but would take to prevent an operating loss or tax credit carryforward from expiring unused
Would result in realization of deferred tax assets.

This Subtopic refers to those actions as tax-planning strategies. An entity shall consider tax-planning strategies in determining the amount of valuation allowance required. Significant expenses to implement a tax-planning strategy or any significant losses that would be recognized if that strategy were implemented (net of any recognizable tax benefits associated with those expenses or losses) shall be included in the valuation allowance. See paragraphs 740-10-55-39 through 55-48 for additional guidance. Implementation of the tax-planning strategy shall be primarily within the control of management but need not be within the unilateral control of management.

30-20 When a tax-planning strategy is contemplated as a source of future taxable income to support the realizability of a deferred tax asset, the recognition and measurement requirements for tax positions in paragraphs 740-10-25-6 through 25-7; 740-10-25-13; and 740-10-30-7 shall be applied in determining the amount of available future taxable income.

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 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.

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:

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
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
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.

30-23 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.

30-24 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.

30-25 See paragraphs 740-10-55-34 through 55-38 for additional guidance related to carrybacks and carryforwards.

Related Implementation Guidance and Illustrations

Recognition of Deferred Tax Assets and Deferred Tax Liabilities [ASC 740-10-55-7].
Offset of Taxable and Deductible Amounts [ASC 740-10-55-12].
Pattern of Taxable or Deductible Amounts [ASC 740-10-55-13].
The Need to Schedule Temporary Difference Reversals [ASC 740-10-55-15].
Operating Loss and Tax Credit Carryforwards and Carrybacks [ASC 740-10-55-34].
Tax-Planning Strategies [ASC 740-10-55-39].
Example 4: Valuation Allowance and Tax-Planning Strategies [ASC 740-10-55-96].
Example 12: Basic Deferred Tax Recognition [ASC 740-10-55-120].
Example 13: Valuation Allowance for Deferred Tax Assets [ASC 740-10-55-124].
Example 19: Recognizing Tax Benefits of Operating Loss [ASC 740-10-55-149].
Example 20: Interaction of Loss Carryforwards and Temporary Differences [ASC 740-10-55-156].
Example 21: Tax-Planning Strategy With Significant Implementation Cost [ASC 740-10-55-159].
Example 22: Multiple Tax-Planning Strategies Available [ASC 740-10-55-163].

5.2.1 The More-Likely-Than-Not Standard

A key concept underlying the measurement of a DTA is that the amount to be recognized is the amount that is “more likely than not” expected to be realized. ASC 740-10-30-5(e) requires that DTAs be reduced “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.”

A more-likely-than-not standard for measuring DTAs could be applied positively or negatively. That is, an asset could be measured on the basis of a presumption that it would be realized, subject to an impairment test, or it could be measured on the basis of an affirmative belief about realization. Because the threshold of the required test is “slightly more than 50 percent,” the results would seem to be substantially the same under either approach. However, some view an affirmative approach as placing a burden of proof on the entity to provide evidence to support measurement “based on the weight of the available evidence.” Regardless of whether an entity views the more-likely-than-not threshold positively or negatively, the entity should fully assess all of the available evidence and be able to substantiate its determination.

Further, the more-likely-than-not threshold for recognizing a valuation allowance is a lower threshold than impairment or loss thresholds found in other sections of the Codification. For example, ASC 450-20-25-2 requires that an estimated loss from a loss contingency be accrued if the loss is probable and can be reasonably estimated. Further, ASC 360-10-35-17 requires that an impairment loss of long-lived assets be recognized “only if the carrying amount of a long-lived asset (asset group) is not recoverable and exceeds its fair value.” In paragraphs A95 and A96 of the Basis for Conclusions of Statement 109, the FASB rejected the term “probable” with respect to the measurement of DTAs and believes that the criterion should be “one that produces accounting results that come closest to the expected outcome, that is, realization or nonrealization of the deferred tax asset in future years.” If the same assumptions about future operations are used, this difference in recognition criteria could cause an entity to recognize a valuation allowance against a DTA but not to recognize an asset impairment or a loss contingency.

5.2.2 Positive and Negative Evidence

In determining whether a valuation allowance is needed, an entity must use judgment and consider the relative weight of the available negative and positive evidence. Further, ASC 740-10-30-23 states, in part, that 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.” For example, information about the entity’s current financial position and income or loss for recent periods may constitute objectively verifiable evidence, while less weight may be given to a long-term forecast of sales and income for a new product.

An entity that has no objectively verifiable negative evidence needs only to determine whether it is more likely than not that the DTA will be realized. If the more-likely-than-not assertion can be supported, often by using management’s subjective projections of future income, there is no need for a valuation allowance. However, if the entity is in a cumulative loss position (which is considered a piece of objectively verifiable negative evidence), it must have objectively verifiable positive evidence to overcome this negative evidence.

While objectively verifiable positive evidence is needed to offset any objectively verifiable negative evidence (e.g., cumulative losses in recent periods) in the assessment of whether a valuation allowance is required, subjective positive evidence (e.g., management’s future income projections that incorporate future earnings growth) may be sufficient to overcome certain types of subjective negative evidence (e.g., negative trends in the entity’s industry outlook that may not be specific to the entity itself). As discussed throughout this chapter, the entity should evaluate both the positive and the negative evidence to determine whether a valuation allowance is required.

5.2.2.1 Cumulative Losses and Other Forms of Negative Evidence

ASC 740-10-30-21 states that “cumulative losses in recent years” are a type of negative evidence for entities to consider in evaluating the need for a valuation allowance. However, ASC 740 does not define “cumulative losses in recent years.” In deliberating whether to define the term, the FASB discussed the possibility of imposing conditions that would require such losses to be (1) cumulative losses for tax purposes that were incurred in tax jurisdictions that were significant to an entity for a specified number of years, (2) cumulative losses for tax purposes that were incurred in all tax jurisdictions in which an entity operated during a specified number of years, (3) cumulative pretax accounting losses incurred in the reporting entity’s major markets or its major tax jurisdictions for a specified number of years, and (4) cumulative consolidated pretax accounting losses for a specified number of years. However, the FASB ultimately decided not to define the term.

Because there is no authoritative definition of this term, management must use judgment in determining whether an entity has negative evidence in the form of cumulative losses. In making that determination, management should generally consider the relevant tax-paying component’s1 results before tax from all sources (e.g., amounts recognized in discontinued operations and OCI) for the current year and previous two years, adjusted for recurring permanent differences. (e.g., meals and entertainment, and tax-exempt interest). Use of a “three-year” convention arose, in part, as a result of proposed guidance in the exposure draft on FASB Statement 109. This guidance was omitted in the final standard (codified in ASC 740) because the FASB decided that a bright-line definition of the term “cumulative losses in recent years” might be problematic. Paragraph 103 of Statement 109’s Basis for Conclusions states that the “Board believes that the more likely than not criterion required by [ASC 740] is capable of appropriately dealing with all forms of negative evidence, including cumulative losses in recent years.” The paragraph further indicates that the more-likely-than-not criterion “requires positive evidence of sufficient quality and quantity to counteract negative evidence in order to support a conclusion that . . . a valuation allowance is not needed.” A three-year period, however, generally supports the more-likely-than-not recognition threshold because it typically covers several operating cycles of the entity, and one-time events in a given cycle do not overly skew the entity’s analysis.

In very rare circumstances, it may be acceptable for entities that have business cycles longer or shorter than three years to use a period longer or shorter than three years to determine whether they have a cumulative loss. To support this determination, an entity must demonstrate that it operates in a cyclical industry and that a period other than three years is more appropriate. For example, a four-year period or a two-year period may be acceptable if the entity can demonstrate that it operates in a cyclical business and the business cycles correspond to those respective periods. If a period other than three years is used, the entity should consult with its income tax accounting advisers and apply the period it selects consistently (i.e., in each reporting period).

Even though there is no bright-line three-year cumulative loss test, the SEC has consistently questioned registrants that had a three-year cumulative loss about why there was not a valuation allowance and asked for documentation to support such a determination.

When determining whether cumulative losses in recent years exist, an entity should generally not exclude nonrecurring items from its results. It may, however, be appropriate for the entity to exclude nonrecurring items when projecting future income in connection with its determination of the amount of the valuation allowance needed. See Section 5.3.2.2.2 for further discussion of the development of objectively verifiable future income estimates.

Cumulative losses are one of the most objectively verifiable forms of negative evidence. Thus, an entity that has suffered cumulative losses in recent years may find it difficult to support an assertion that a DTA could be realized if such an assertion is based on subjective forecasts of future profitable results rather than an actual return to profitability.

The examples below illustrate different types of negative evidence that an entity should consider in determining whether a valuation allowance is required.

Example 5-1

Cumulative Losses in Recent Years

An entity has incurred operating losses for financial reporting and tax purposes over the past two years. The losses for financial reporting purposes exceed operating income for financial reporting purposes, as measured cumulatively for the current year and two preceding years.
A currently profitable entity has a majority ownership interest in a newly formed subsidiary that has incurred operating and tax losses since its inception. The subsidiary is consolidated for financial reporting purposes. The tax jurisdiction in which the subsidiary operates prohibits it from filing a consolidated tax return with its parent. This would be negative evidence for the DTA of the subsidiary in that jurisdiction.

Example 5-2

A History of Operating Loss or Tax Credit Carryforwards Expiring Unused

An entity has generated tax credit carryforwards during the current year. During the past several years, tax credits, which originated in prior years, expired unused. There are no available tax-planning strategies that would enable the entity to use the tax benefit of the carryforwards.
An entity operates in a cyclical industry. During the last business cycle, it incurred significant operating loss carryforwards, only a portion of which were used to offset taxable income generated during the carryforward period, while the remainder expired unused. The entity has generated a loss carryforward during the current year.

Example 5-3

Losses Expected in Early Future Years

An entity that is currently profitable has a significant investment in a plant that produces its only product. The entity’s chief competitor has announced a technological breakthrough that has made the product obsolete. As a result, the entity is anticipating losses over the next three to five years, during which time it expects to invest in production facilities that will manufacture a completely new, but as yet unidentified, product.
An entity operates in an industry that is cyclical in nature. The entity has historically generated income during the favorable periods of the cycle and has incurred losses during the unfavorable periods. During the last favorable period, the entity lost market share. Management is predicting a downturn for the industry during the next two to three years.

Example 5-4

Unsettled Circumstances That if Unfavorably Resolved Would Adversely Affect Profit Levels on a Continuing Basis in Future Years

During the past several years, an entity has manufactured and sold devices to the general public. The entity has discovered, through its own product testing, that the devices may malfunction under certain conditions. No malfunctions have been reported. However, if malfunctions do occur, the entity will face significant legal liability.
In prior years, the entity manufactured certain products that required the use of industrial chemicals. The entity contracted with a third party, Company X, to dispose of the by-products. Company X is now out of business, and the entity has learned that the by-products were not disposed of in accordance with environmental regulations. A governmental agency may propose that the entity pay for clean-up costs.

Example 5-5

A Carryback or Carryforward Period That Is So Brief That It Would Limit Realization of Tax Benefits if (1) a Significant Deductible Temporary Difference Is Expected in a Single Year or (2) the Entity Operates in a Traditionally Cyclical Business

An entity operates in a state jurisdiction with a one-year operating loss carryforward period. During the current year, it implemented a restructuring program and recorded estimated closing costs in its financial statements that will become deductible for tax purposes next year. The deductible amounts exceed the taxable income expected to be generated during the next two years.

5.2.2.2 Positive Evidence Considered in the Determination of Whether a Valuation Allowance Is Required

When an entity has negative evidence, such as a cumulative loss position, it should also evaluate what positive evidence exists. ASC 740-10-30-22 gives the following examples of positive evidence that, when present, may overcome negative evidence in the assessment of whether a valuation allowance is needed to reduce a DTA to an amount more likely than not to be realized:

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
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
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.

The example below illustrates situations in which entities have positive evidence that may indicate that a valuation allowance would not be necessary.

Example 5-6

Scenarios Based on ASC 740-10-30-22(a)

For example:

An entity enters into a noncancelable long-term contract that requires the customer to purchase minimum quantities and that therefore will generate sufficient future taxable income to enable use of all existing operating loss carryforwards.
During the current year, an entity merges with Company L, which operates in a different industry that is characterized by stable profit margins. The tax law does not restrict use of preacquisition NOL carryforwards. Company L’s existing contracts will produce sufficient taxable income to enable use of the loss carryforwards.

Scenario Based on ASC 740-10-30-22(b)

An entity has invested in land that has appreciated in value, and the land is not integral to the entity’s business operations. If the land were sold at its current market value, the sale would generate sufficient taxable income for the entity to use all tax loss carryforwards. The entity would sell the land and realize the gain if the operating loss carryforward would otherwise expire unused. After considering its tax-planning strategy, the entity determines that the fair value of the entity’s remaining net assets exceeds its tax and financial reporting basis.

Scenario Based on ASC 740-10-30-22(c)

An entity incurs operating losses that result in a carryforward for tax purposes. The losses resulted from the disposal of a subsidiary whose operations are not critical to the continuing entity, and the company’s historical earnings, exclusive of the subsidiary losses, have been strong.

Examples 5-7 through 5-10 2 illustrate additional situations in which entities that have had negative evidence might conclude that no valuation allowance is required (or that only a small valuation allowance is necessary) as a result of available positive evidence.

Example 5-7

An entity experienced operating losses from continuing operations for the current year and two preceding years and is expected to return to profitability in the next year. Positive evidence included (1) completed plant closings and cost restructuring that permanently reduced fixed costs without affecting revenues and that, if implemented earlier, would have resulted in profitability in prior periods and (2) a long history during which no tax loss carryforwards expired unused.

Example 5-8

An entity with a limited history incurred cumulative operating losses since inception. The losses were attributable to the company’s highly leveraged capital structure, which included indebtedness with a relatively high interest rate. Positive evidence included a strict implementation of cost containment measures, an increasing revenue base, and a successful infusion of funds from the issuance of equity securities, which were used, in part, to reduce high-cost debt capital.

Example 5-9

An entity incurred cumulative losses in recent years; the losses were directly attributable to a business segment that met the criteria in ASC 205-20 for classification as a discontinued operation for financial reporting purposes. Positive evidence included a history of profitable operations outside the discontinued segment.

Example 5-10

An entity suffered significant losses in its residential real estate loan business. The entity has recently discontinued the issuance of new residential real estate loans, has disposed of all previously held residential real estate loans, and has no intention of purchasing real estate loans in the future. Positive evidence included a history of profitable operations in the entity’s primary business, commercial real estate lending.

Footnotes

As described in ASC 740-10-30-5, a tax-paying component is an individual entity or group of entities that is consolidated for tax purposes.

Note that similar examples may not result in a similar conclusion. An entity must use judgment in determining whether a valuation allowance is necessary.

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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.