The last few weeks have been a wild ride for the global economy. Between the violent swings in the stock market, continuing high unemployment and mixed earnings results on Wa l Street, a company's fortunes can change rapidly. With the continued uncertainty in the direction of the global economy, the spotlight remains on deferred tax assets reflected on corporate balance sheets and whether they wi l ultimately be realized. As the end of the third quarter starts to come into view (for calendar-year companies), now is the time for your company to revisit its valuation a lowance assessment.
As we a l know, Accounting for Income Taxes under ASC 740 is a significant area of focus for companies, but the technical aspects of the valuation a lowance rules can trip up even a best-in-class tax department. Within ASC 740, the valuation a lowance assessment is one of the areas of accounting practice that ca ls for the most judgment. It requires management to assess both positive and negative evidence, look at historical results, project the future and then make a "more likely than not" decision that its deferred tax assets wi l be realized. Then the fun begins: defending that decision, sometimes with hindsight available to second-guess the conclusion.
However, if the finance group in coordination with the tax department pays attention to the process of gathering, reviewing and documenting the information used in making the valuation a lowance assessment, the timing of the analysis and the ability to support the decision with your audit firm is greatly improved.
Let's start with a review of the valuation a lowance rules:
A valuation a lowance is needed when a l existing evidence, both positive and negative, indicates it is "more likely than not" (greater than 50 percent) that a deferred tax asset wi l not be realized. The determination of whether a deferred tax asset wi l be realized requires an assessment of whether future taxable income wi l exist, of the appropriate character, within the period that the deferred tax asset reverses or within an a lowable carryback or carryforward period. (ASC 740-10-30-5)
As previously mentioned, this determination is based on a l available evidence. What evidence should be gathered and assessed when making the valuation a lowance assessment?
The old adage goes "past results do not guarantee future performance," but in the world of valuation a lowances, past results genera ly provide the starting point and the most objective evidence available.
Cumulative Past Results
Determining recent historical performance should be the first step in the valuation a lowance assessment. The general rule (though not specifica ly stated in ASC 740) is pre-tax book income, adjusted for permanent book-tax differences, over the past three years (the current year plus the prior two years). For companies reporting quarterly information, this analysis should be in the form of a ro ling 12-quarter cumulative results calculation. With the economic recovery of the past two years, dating back to mid-2009, there may be many companies with eight quarters of positive results. If the fu l 12-quarter result is cumulative income, a strong piece of evidence exists on the positive side of the ledger. If cumulative losses have occurred, this negative, objective evidence can be difficult to overcome. Other historical evidence that should be considered includes the use or expiration of historical tax attributes. A history of deferred tax — net operating losses (NOLs) or other tax attributes, such as credits — expiring prior to use is further negative, objective evidence.
Sources of Taxable Income
ASC 740-10-30-18 provides four possible sources of future taxable income that may be available and can be used to support the realization of deferred tax assets. These sources are:
1. Future reversals of existing taxable temporary differences;
2. Future taxable income exclusive of reversing temporary differences and carryforwards;
3. Taxable income available for prior carryback years (if carryback is a lowed by the appropriate tax laws); and
4. Tax planning strategies.
Each of these sources needs to be documented and updated based on changes as they occur.
Future Reversals of Existing Taxable Temporary Differences
This source of taxable income requires a process of scheduling the reversal of existing taxable temporary differences (TTDs) to demonstrate that the timing of reversals creates taxable income. Because certain TTDs reverse in a predictable pattern, this process can be viewed as objective.
Taxable Income in Current Years That Can Be Carried Back to Prior Tax Years
Taxable income that meets the jurisdictional tax laws to be carried back to earlier loss years, a lowing realization of a deferred tax asset, is highly objective evidence. It is important to ensure that the local jurisdictional requirements are analyzed and fo lowed to ensure that proper character and timing of a potential carryback are fo lowed. Additiona ly, care must be taken to address and assess any tax implications of the income carryback, such as the potential for tax credits becoming available in these prior years. Ultimately, realization of deferred tax assets must occur in order to view the carryback as a source of deferred tax asset realization.
Tax Planning Strategies
Tax planning strategies that could provide a means of realizing deferred tax assets are another source of taxable income. These strategies need to be both prudent and feasible, as we l as an action that the company ordinarily would not undertake but for the need to avoid a net operating loss (NOL) or tax credit from expiring unused. To meet the requirements of ASC 740-10-30-19, strategies evaluated to be prudent must be in the best interest of the company. Feasible tax strategies must be available and in the control of the company. Lastly, the strategy must be one that the company would not norma ly undertake but asserts that it wi l in order to avoid the loss of an NOL or tax credit. Tax planning strategies also require the realization of the deferred tax asset, not just a refreshing of the asset. Therefore, actions that just extend an NOL's useful life, by replacing an old NOL with one that wi l be generated in the future, wi l not qualify as a tax planning strategy.
Projections of Taxable Income
Future taxable income projections exclusive of reversing TTDs and carryforwards are projections that by their very nature are subjective, especia ly in an uncertain economy. This source should be used to provide support for future taxable income, which wi l eventua ly be required to demonstrate deferred tax asset utilization. For many companies, projections are frequently updated. Make sure the projections used for valuation a lowance purposes are the same as those used for other management purposes. With the recent swing in projected growth rates for the second half of 2011 and thereafter, growth expectations from the first half of 2011 may no longer be accurate. Also, the third quarter is frequently when companies start the budgeting process for the upcoming year. These new projections can provide the most current source of projections for the rest of 2011 and 2012.
Weighing the Evidence
The valuation a lowance threshold is a "more likely than not" standard (meaning more than a 50 percent probability). Assessing the weight of the existing evidence requires a company to compare the positive and negative evidence, understanding that objective evidence carries greater weight. Therefore, to meet the "more likely than not" standard, a company with negative evidence (from recent cumulative losses, for example) wi l need to support its assessment with substantial positive evidence (including objective, positive evidence). As stated earlier, if recent objective negative evidence exists, it can be very difficult to provide sufficient offsetting positive evidence to overcome the need for a valuation a lowance.
As previously discussed, the recent swings in the global economy may create changes in the support used as sources of taxable income. The process fo lowed in analyzing the need for a valuation a lowance needs to be we l supported, as this assessment is one that is subject to scrutiny by the financial statement auditors and the Securities and Exchange Commission. Clear, reasonable and documented information and decisions should exist for the support of the valuation a lowance and any change in conclusion. Most financial statement auditors have national office review the valuation a lowance decision made by management. This process can take time, so early discussions with the auditor are suggested when management is considering its valuation a lowance decision. Additiona ly, the valuation a lowance decision is one for which SEC staff periodica ly requests information. These requests focus on the decisions made and wi l occur at a point where hindsight is available.
The same scrutiny can occur if there are no apparent reasons for a change in a valuation a lowance conclusion. If a change is made at year-end but the evidence is unchanged from an earlier quarter, say the third quarter, questions may be asked as to why the change didn't occur in the earlier period. This situation highlights the need to stay attuned to changes in facts and the underlying evidence available to support the valuation a lowance conclusion. Those in the tax department should not be the last ones to know that the sources of taxable income that have been a source of evidence have changed.
Alvarez & Marsal Taxand Says:
The analysis and conclusions reached in evaluating the need for a valuation a lowance are based on managementís decisions and existing evidence (positive and negative), with objective evidence given the greatest weight. As the underlying sources of evidence change, tax departments need to monitor and update their assessments. This is especia ly true in situations where the evidence is narrowly supported in favor, either in support of an existing a lowance or the existing need for no a lowance. The third quarter is an exce lent time for this assessment. Waiting to address the valuation a lowance assessment (or update the existing assessment) until the year-end provision may create additional work in an already busy time. Given the uncertainty about the direction of the global economy, the evidence that your company has used to support its valuation a lowance decisions may be changing as well.
As provided in Treasury Department Circular 230, this publication is not intended or written by Alvarez & Marsal Taxand, LLC, (or any Taxand member firm) to be used, and cannot be used, by a client or any other person or entity for the purpose of avoiding tax penalties that may be imposed on any taxpayer.
The information contained herein is of a general nature and based on authorities that are subject to change. Readers are reminded that they should not consider this publication to be a recommendation to undertake any tax position, nor consider the information contained herein to be complete. Before any item or treatment is reported or excluded from reporting on tax returns, financial statements or any other document, for any reason, readers should thoroughly evaluate their specific facts and circumstances, and obtain the advice and assistance of qualified tax advisors. The information reported in this publication may not continue to apply to a reader's situation as a result of changing laws and associated authoritative literature, and readers are reminded to consult with their tax or other professional advisors before determining if any information contained herein remains applicable to their facts and circumstances.
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Alvarez & Marsal Taxand, an affiliate of Alvarez & Marsal (A&M), a leading global professional services firm, is an independent tax group made up of experienced tax professionals dedicated to providing customized tax advice to clients and investors across a broad range of industries. Its professionals extend A&M's commitment to offering clients a choice in advisors who are free from audit-based conflicts of interest, and bring an unyielding commitment to delivering responsive client service. A&M Taxand has offices in major metropolitan markets throughout the US., and serves the U.K. from its base in London.
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