So just to discuss valuation allowance, we have to revisit deferreds and if anyone wants a deeper dive on the subject of deferreds, we have an episode [https://www.iono.fm/e/1078373] all about them and please check that out. But for now, let’s just do a quick recap of deferreds and what they have to do with valuation allowance.
So when we mentioned deferreds, we’re referring to a company’s deferred tax roll forward, which ultimately provides a company’s deferred tax asset and deferred tax liability amounts on an item-by-item basis and this kind of granular breakdown of DTAs and DTLs as they’re called at the end of the year, is then summarized and presented in the company’s tax footnote, right in the financial statements.
So recall for US public companies, that would be the form 10-K, and then private companies and foreign companies have similar requirements as well.
On the financials themselves, the breakdown of DTAs and DTLs is ultimately summarized to land on a total deferred tax asset and-or deferred tax liability, which makes its way onto a company’s balance sheet. So one of the core financial statements, the balance sheet. And let’s recall what typically makes up deferred tax assets and liabilities, and these include temporary book-to-tax differences, so timing differences, net operating loss carry forwards, and tax credit carryforwards. Those are kind of the three main pillars of what makes up deferred tax assets and liabilities.
And the reason these items result in deferred tax assets and liabilities to begin with, is because deferred tax is really meant to track the impact of items on future tax returns. So with deferred tax assets resulting in a future tax benefit, like a future deduction or a credit, and then deferred tax liabilities resulting in a future tax expense, like a future item of income.
So the current provision really gets us to an estimate of current tax liability or benefit for the year. And it’s a precursor for our current year tax return done several months later. The deferred provision on the other hand is forward-looking tracking what will impact a company’s tax liability or benefit in future years.
And then the last point to make is: Let’s recall the deferred roll forward does not track any permanent book-to-tax differences. Since these are differences in treatment of an income or expense item between accounting and tax, that will never reverse in the future. And this, of course, is quite different than temporary differences, which are differences in treatment of an income or expense item between accounting and tax that will reverse in the future. So as opposed to a permanent difference, these temporary differences are truly temporary in nature, or really just a difference of the timing of a deduction or income inclusion between book and tax
Indeed. And can you review how deferreds fit into the overall tax provision process?
If we back to what we covered on some of the earlier episodes of the podcast, we discussed that there are a few core tax provision calculations in the whole tax provision process, and we could really narrow it down to three, essentially.
So typically, a company will begin provision process with completing their current provision first, which I just mentioned is that calculation that gets us to our current year estimate of tax liability. And then following completing the current provision, second: Companies will generally hop over to a different rule forward and they’re there the work their way through this schedule. And then following that, third: Companies will go ahead and do the rate reconciliation, which explains and proves out that effective tax rate, which we’ve talked about in detail on other episodes as well.
And of course I’m leaving out many of the finer details here, but this is kind of just a high level lay of the land in terms of the provision process. And you could see how the deferred roll forward sort of sits in the middle, but it is a core component. And typically one that companies are really keenly focused on getting right. And auditors, financial statement auditors, like accounting firms that review the provision – they’re really keenly focused on reviewing it quite closely and actually proving out the ending balances on this deferred roll forward against supporting work papers.
So it’s a calculation that gets a lot of attention and the majority of companies will spend, honestly, the most amount of time in their provision process focusing on their deferred roll forward. It’s sort of above and beyond the other provision schedule, just given it’s detailed and at times complex nature.
All right. And with that background, now let’s get to the focus of today’s episode. What is valuation allowance and how does this come into play in terms of a deferred roll forward?
So as noted, the final product of the deferred roll forward is arriving at that deferred tax asset or liability figure that goes on a company’s balance sheet; which is one of those, as I mentioned, core financial statement schedules that really gets a lot of attention from the investing community and other interested parties.
So of course this schedule should be correct and accurately state a company’s asset and liability position. And in this vein, misstating a company’s assets or liabilities would be misleading for investors and other financial statement users. And companies, when you think about it, would have an incentive generally to overstate assets, to make it look like they have more assets and understate liabilities, to make it look like they have less liabilities for obvious reasons. And so the way the accounting rules address this issue particularly related to tax, and ensure that deferred tax assets and liabilities are appropriately stated, is through this valuation allowance mechanism.
So what evaluation allowance does is it forces a company to look at their deferred tax assets in particular and to say, “Is this asset appropriately stated?”
And if not, a company needs to reduce this deferred tax asset to an amount that is appropriately stated, and represents the true future tax benefit that the company expects it will receive in the future from this asset, the mechanism used to reduce the deferred tax asset to the appropriate amount, that a company actually expects to receive a future tax benefit on, is by putting up a valuation allowance against the DTA. And I’ll refer to valuation allowances as VA for short, and DTA of course means deferred tax asset.
So when I just gave basically as a practical definition of what a VA does, and I’ll also provide more of the technical tax accounting jargon definition as well.
I did feel that it was almost that point of the episode where we begin to use more abbreviations, [Howard laughs]… But now that we’ve properly set the stage, I think our listeners will be okay.
We were overdue, right? [Laughs.]
So getting into more of the weeds technical definition, so ASC740 – there’s another abbreviation for you. So the accounting standard that kind of dictates the treatment of income taxes under a US GAAP states that companies must reduce deferred tax assets by a valuation allowance, if based on the weight of available evidence, it’s more likely than not – which has a likelihood of more than 50 percent – that some portion or all of the deferred tax assets will not be realized. And obviously there’s quite a bit to unpack here.
So first, we could see that the valuation allowance serves to bring the deferred tax assets of a company, to an amount that they expect to realize, the amount that will actually yield a future tax benefit. And this makes sense the valuation allowance or VA, as I mentioned and people call it, bring the DTA to really its correct value and serves not to overstate a company’s assets.
But then, with that, the next question comes along: Well, how has this determination made? And the number two [question] is: How is it measured?
So you can see the literature says, this is determined based on the weight of available evidence. We will talk about what exactly that means.
So that’s how it’s determined and obviously that’s pretty vague, but then how is it measured once you need potentially a valuation allowance, how do you know how much you need? So the question of measurement is another issue here. And the literature basically says that companies must record a VA against this DTA, if it’s more likely than not, or greater than 50 percent chance that some or all of the DTA will not be realized. So we’ll talk about how that measurement is done and how it could certainly be a bit of a subjective determination as well in many cases.
Indeed. And even before we drill down on this and discuss even those finer points, when we talk about valuation allowances, is this a worldwide concept or does this really only apply to US headquartered companies?
Yes, that’s a great question. And the concept of valuation allowance really is a US concept under US GAAP. However, and it’s a big ‘however’ – IFRS the international standard does provide that companies can only record deferred tax asset if it’s probable.
So if it’s probable that the asset will be realized and this probable standard generally comes down to a likelihood of more than 50 percent, which is really similar to US GAAP’s more likely than not standard that I just kind of alluded to.
So practically, US GAAP and IFRS are fairly aligned that deferred tax assets should be provided at their appropriately stated value, which is the amount that is more likely than not or probable right greater than 50 percent, to be realized. And practically, US headquartered companies are supposed to record the full deferred tax asset and then reduce it by a valuation allowance under US GAAP. While on the other hand, foreign based companies under IFRS, just simply record the deferred tax asset at its probable value.
So recording kind of a net, as opposed to the gross plus evaluation allowance to reduce it. There’s a bit of a differentiation in kind of practical approach here, but essentially at the end of the day, the end result is very similar. It kind of gets you to a similar place.
And with that distinction between the US and foreign accounting standards, and before we get deeper into the details surrounding how a VA is determined – at a high level, why is a valuation allowance important to the tax provision?
It’s really all about fairly stating those deferred tax assets and ensuring a company’s balance sheet is appropriately stated. You’re not overstating any assets.
And it’s not just the balance sheet that the VA impacts. It also influences a company’s total income tax expense. It influences earnings as a whole because of that, and then it influences the effective tax rate as well because of that.
And to understand why this is, we actually need [laughs] to do a quick lesson in journal entries – everyone’s favorite activity from Accounting 101. And of course, journal entries are kind of the language accounting and it’s all about debits and credits. And when we talk about tax accounting, it’s really no different.
So let’s think of what a journal entry is when a company sets up a deferred tax asset, or in this case, an unfavorable temporary difference. So in this case you would debit current tax expense, so you debit the profit and loss, and then you credit your current tax payable. So you’re adding more tax expense and then you’re recording a payable. And that reflects kind of the impact of the temporary differences on the current provision.
So we’re touching current tax expense. It drives up current tax expense, and then it causes companies to owe tax this year, via that payable mechanism. So that’s kind of the first part of the entry and that’s where it touches the current provision.
But then there’s a second part of the entry, because remember a temporary difference, not only affects this year, but it affects future years. And this part of the entry, you need to debit deferred tax asset and you need to credit deferred tax benefit. And this reflects, the impact of the temporary difference on the deferred provision, where you’re recognizing the future tax benefit for this item in the income statement and accruing that deferred tax asset to the balance sheet for the future tax benefit that the company will get.
And before any consideration of valuation allowance, those were the core entries of a temporary difference. And as we discussed on the rate [reconciliation] episode [https://www.iono.fm/e/1081235], a temporary differences don’t impact the effect of tax rate. And the reason for that when you think about the journal entries, it’s because the deferred tax benefit and the current tax expense are recorded for the same exact amount, but one’s a debit and one’s a credit. So they’re going opposite ways and they basically net out, and they cancel out. So they ended up being the zero impact to your total tax expense, and therefore they don’t get back to your effective tax rate, which of course, is total tax expense divided by pre-tax book income. It’s kind of two sides of the same coin.
So now let’s take one step further and let’s say a company determines they need a valuation allowance on this DTA they just recorded. And we’ll get into how that determination is made in a little bit. But if they decide they do need the VA, then they basically have to record the following journal entries.
So they would debit deferred tax benefit, or P&L, and then they credit valuation allowance. So here we put up the valuation allowance, which serves to reduce that deferred tax asset balance on the balance sheet. But the other side of the entry is reducing the deferred tax benefit, or it’s an income statement item, a P&L item. So that impacts our total tax expense directly.
And here, by removing or reducing the deferred tax benefit from the equation, this actually results in a higher total tax expense. And this higher total tax expense, what does it do? It drives our earnings down and it drives our ETR up.
So this is really a major reason why valuation allowances.. they’re such a key topic. And one that is really highly scrutinized and highly focused on in tax departments, because any changes to it directly impact earnings and directly impact the ETR.
And in the case of putting a valuation allowance up or increasing a VA, it’s a negative impact – it drives tax expense up and the ETR up. But it works the other way around too; where, if it is determined that a VA is previously recorded is no longer needed – and we’ll get into, once again, how that determination is made – but if it is the side of it, you used to have a VA and now you don’t, or you need less VA. Then a company would pull down their VA and they would do that by debiting the valuation allowance and crediting the for tax benefit again.
So you could see this actually drives total tax expense down as we are removing the VA, and we’re restoring our DTA to its original value, and we’re putting the deferred tax benefit, that P&L benefit, back up. So with this, it would bring a company’s ETR down. It would raise profitability up, given the lower total tax expense that results.
So that’s sort of a high-level overview of how VAs impact both the balance sheet, but then also the income statement. And it really impacts that ETR as well. And given that impact and the fact that the determination of this measure could be a bit subjective, which we’ll get into – this is why VAs are so important to the provision and really our key focus in the whole provision process.
In which case, we may get into some level of subjectivity here. Why don’t we circle back to how companies determine they need a VA? And if they do determine they need one, how do they go about figuring out the amount.
Let’s go back to our deferred tax asset types. So generally, deferred tax assets result from unfavorable temporary book-to-tax adjustments, net operating loss carry forwards, and tax credit carryforwards. So these are sort of all the ways in the future to essentially drive down tax expense, be it through the reversal of a temporary difference and a future deduction or the future net operating loss or a credit that you could offset tax expense with.
So really, the key to the determination of if these DTA are going to be useful and worth anything is if a company expects to have future taxable income, and therefore tax liability; because if not, they don’t expect any income or tax expense in the future and these DTAs will just go to waste. And they’re either going to expire unused, or they’re just going to sit around there, being useless.
So in determining if a valuation allowance is needed, a company looks at their income and by the way, this determination is done on a jurisdictional basis. So looking at US federal, each US state individually, and then each foreign jurisdiction with separate tax paying components.
So a company will look to each of its jurisdictions for sources of income and getting a little bit more technical, these generally include four potential items, and this is sort of an order of importance.
So if a company is looking for income, where could they look for income? So, one: They could look for income in prior carryback years. So if you’re allowed to carry back your net operating loss to offset income in a prior year, of course, that would be an easy way to utilize that DTA that resulted from the NOL and therefore you wouldn’t really needed a valuation allowance because you’re able to use up that asset and you’re able to carry back offset income in a prior year.
And you’re able to use that DTA take advantage of it, lower your tax expense from a previous year, you could utilize that and you wouldn’t need a valuation allowance because of that. That’s one, and that’s kind of the most objective evidence and the gold standard of why you wouldn’t need a VA.
Another source of income is kind of looking forward to the future. And it’s looking at a future reversal of favorable temporary differences. So if a company recognized the tax deduction this year, but not any book expense, or in other words, it accelerated the tax deduction – this is a source of income. As in the future, when the book expense is recognized, it will be reversed out for tax purposes, increasing the taxable income in the future. And this would apply for income recognized this year for books, but what we recognize in the future for tax as well.
So basically looking at what’s going to happen in the future, is there going to be taxable income generated because of these timing differences? If so, that is a future source of income, that’s also fairly objective, right? Because you know what your timing differences are at this moment in time.
And a key exercise related to this particular source of income is something known as scheduling out the reversal of the temporary differences, because this would ensure that your favorable temporary difference reverses in the right years prior to the expiration of any tax attributes like an NOL or credit or whatever it may be. So those are two sources. And then, you know, as we work our way down, these sources get a little bit less subjective as we go. So the next one is looking at future taxable income without accounting for temporary differences in carryforwards.
We’re thinking in the future and that’s all based on management projections that of course gets really into subjective determination. And that’s kind of why the first two income sources are more important in this analysis than these future income projections.
That’s number three, and then number four, another source of income and this is kind of the most subjective, and one that generally can’t be relied on its own. It would kind of need to be combined with another source of income. So the account is like a real support to support the realization of these DTAs. But this one is tax planning strategies.
So does the company have any tax planning strategies to increase their taxable income? It could be from the sources noted above, but how are they going to increase their taxable income to actually burn through their attributes and not let them expire unused?
So if a company goes through this analysis and determines where are its sources of income, what it takes is evidence of one or more source of taxable income to support a conclusion that no VA is needed. So particularly it’s those first you mentioned: carryback availability and future reversals of favorable temporary differences. Those are the most objective and the most important in the analysis, much more important and objective then future taxable income projections and tax planning strategies.
And then, when we’re thinking about this determination – or will the company having come in the future, because they need that income in order to actually be able to recognize these deferred tax assets and not put that valuation allowance up – what companies need to do is they also need to look at all the positive evidence related to this determination and all the negative evidence.
So positive evidence is kind of just those items that we just talked about along with strong earnings history – so proving that you’ve earned a lot of income in the past, and that could be that you have sales backlog, expected to produce taxable income in the future. You could have a new customer signing to come as well to kind of support a company’s position that their DTA is revisable and no VA is needed.
So these taxable income sources could come from a few different places, but positive evidence means that you’re going to generate that taxable income, or you have that source in the past.
And then negative evidence on the other side does just the opposite, and it would start shifting the analysis the other way where a VA could potentially be needed. So a company would look at their positive evidence and if there’s not a lot, then they have to start looking at their negative evidence and say, “Have we had a lot of cumulative losses in recent years? Do we have a lot of past losses? Do we expect a lot of future losses? Do we have a history of any loss carry forwards and credit carryforwards kind of expiring unused, are there unfavorable trends in the business? Can management not really forecast earnings properly?”
These would all be negative evidence and the more negative evidence that piles up, it’s a greater likelihood that a company would need to record this valuation allowance, because if they’re not going to earn income in the future, they’re not going to be able to recognize that deferred tax asset.
So as you could probably tell, given how companies need to consider all this different information – positive evidence and negative evidence – in order to ascertain if it needs a valuation allowance, this analysis is at times difficult and it could come down to some subjective measures like projections and even tax planning strategies and certain situations.
So typically, companies have incentives to not want to be an evaluation on its position, given the negative earnings and ETR hit that they have to take when putting up the VA. And then on the other side, companies who are in a VA, they want to come out of it usually, to get that earnings and ETR boost as such.
Because financial statement auditors are really keenly interested in how companies determine the need for a VA, and they review this decision making process, the positive evidence, the negative evidence… They review it closely and ensure they’re aligned and in agreement with management’s decision. And then if it gets even trickier, honestly, when determining the amount of the VA, and if a company may need a partial VA against its deferred tax assets and not a full VA, but only a piece of the DTA needs to be reduced.
And that could be because the company determines it’s more likely than not that it will realize a portion of the DTA based on all the positive and negative evidence, but not the full amount. So I’ll just give a really quick example.
So let’s say a company with a DTA of a hundred bucks expects to earn enough income to support $60 of its DTA, based on all of the evidence at hand. Then it would need a $40 valuation allowance. So it wouldn’t need the full amount of the DTA to be reduced by the VA, but just a portion, just that $40. On the other hand of course, that company could have also looked at the weight of all evidence and said on that $100 DTA, “I actually do need a full VA because I’ve way more negative evidence and positive evidence. And it doesn’t look like I’m going to be able to get any benefit from his future DTA. I’m not going have the income to be able to take advantage of the future expenses and future credits to come. So therefore, I’m going to put up a full VA of a hundred bucks and that’s going to reduce that DTA to zero.”
So likewise, since this determination is on a jurisdictional basis, a company could say they need a VA on certain state attributes or certain international attributes, or obviously federal attributes – but it may not need a VA on everything. So nobody’s needs to look at each DTA in each jurisdiction – they need to look at all the positive evidence, all the negative evidence – and then make the determination from there, making this a really detailed and pretty tricky analysis.
Does the evaluation allowance stay the same from year to year, and if not, what causes it to fluctuate?
This analysis that we just discussed above actually has to be done on a quarterly basis for US companies. So companies need to look at the realizability of their DTAs on each financial statement, be it quarterly or annually, and they need to assess if those DTAs are realizable, or if they need a VA. And if they have a VA or need one, they need to determine the appropriate amount, which fluctuates with the amount of the DTA. So if the DTA went up because the company had another year of a loss, another net operating loss that they spit out, the DTA goes up because net operating loss carry forward generates a DTA. Then the VA is going to potentially move with it. It’s going to generally follow suit and go up as well.
But then separately from just the movement in the DTA, you also need to look at your analysis and say, “Okay, based on all the positive evidence at hand, based on all the negative evidence at hand, do I still need a VA on my DTA?”
If the answer is yes, then once again, you need to go to the measurement and figure out, “Okay, well, how much VA do I need against my DTA? How much is my DTA is more likely than not to be realized and vice versa?”
So outside of just kind of the regular fluctuations in the DTA and how that impacts the VA, you also need to go through that analysis exercise in each quarter for US companies and generally more of an annual process for foreign companies. But when this change occurs, you do need to recognize it in the financial statements. So it is something that companies are really focused on, on a quarterly and annual basis and something that auditors look at, generally, every time their auditing financial statement be quarterly or annual.
And what are the most common companies that tend to need a valuation allowance.
VAs they’re really common to see in loss companies. So given the fact that they generate DTAs from their net operating loss carry forwards, and their are other unused attributes, like a tax credit carry forward. They can’t use those DTAs since they’re in a loss position and they’re not generating any income and therefore they’re not generating any tax expense. So these companies usually end up having to put up a valuation allowance and, if they kind of stay in that loss position over time, they have to remain in that valuation allowance position.
Of course, if trends change and all of a sudden they start generating income and coming out of that loss position, that completely changes the analysis. Then all of a sudden, maybe you have some positive evidence that outweighs your negative evidence and potentially you could get rid of the VA, but generally, it’s really loss companies that tend to have this valuation allowance.
And when we think about which kinds of companies could be loss companies, this could include startups, right? So companies pretty early in their life who haven’t quite yet turned to profitability. And there isn’t enough positive evidence like the reversal of favorable timing differences. Obviously, they don’t have a strong earnings history because they’re fairly new. They don’t have big future income projections just yet. They don’t have a strong pipeline of customer orders, et cetera.
So it could include startups just because they don’t have that positive evidence and they really have a lot more negative evidence – history of losses, kind of not generating income yet. They don’t have really favorable objections on hand. So, you know, startups are a very common type of company that would have a valuation allowance.
Another type of company could be those companies really hit hard by COVID. Pandemic really hit a lot of businesses hard. And if a company was maybe struggling pre COVID, this really accelerated it generally across the board and put many companies over the edge of having that, maybe negative evidence exceed the positive evidence, and that caused some of these companies to have to put up VAs that didn’t have valuation allowances in the past, because you always have to look at that mix of evidence.
And every quarter, every year that evidence could change and all it takes is something like COVID to completely change the dynamics of a business. And if that happens, then of course, you have to look at your valuation allowance and say, “These the for tax assets I have on my balance sheet, these future tax benefits, they think I’m going to be getting… will I be getting them in the future?”
Now, because of the way companies can be struggling? Maybe not, maybe they won’t be getting in the future. And if they determine it’s not more likely than not, that they’re going to get them right. If they don’t hit that 50 percent threshold and they would have to put up a VA, those are kind of lost companies and out of the whole bit for pretty large valuation allowances, potentially.
But then outside of loss companies, there are even profitable companies who have valuation allowances as well. So for example, let’s just say that a large profitable company who operates all around the world, but maybe one jurisdiction, one country that they operate in, they’re not so profitable; but all around the rest of the world, they’re doing great. So you could have a company profitable across the whole world, but in one country or in one state, it generates a loss consistently. For some reason, maybe it just hasn’t taken off that company in that one country, or there’s some financial reasons for it to not really be in an income position year after year. It could be a state, it could be a country.
So that could be a scenario where you actually need a partial valuation allowance just related to that one particular jurisdiction, or maybe there’s a couple of them. This is all to say basically that, valuation allowances while they’re much more common and are much more material, for loss companies – and that includes startups companies that have had COVID, etc.—it’s really a broad concept and one that almost every company needs to reckon with.
Because most companies, even the most successful ones, they will need to look across all their jurisdictions and say, “Are all of our jurisdictions successful? Are all of our jurisdictions DTAs going to be recognized?”
And if the answer is no to any particular jurisdiction or set of jurisdictions, then you would need to potentially put up that VA.
It’s a broad concept. There is some subjectivity here and companies are really keenly focused on this as they go through their quarterly and annual provisions.
And just to recap everything we’ve gone over today, because I know Howard’s done such a great job of explaining it, but a valuation allowance is an amount used to offset a deferred tax assets, such as a net operating loss or tax credit that a company is not likely to realize due to say, continually operating at a loss. This amount must be continually reassessed to ensure it doesn’t need to be increased or decreased or, should any changes need to be made, a journal entry can be added to make the necessary adjustments. Ultimately, the valuation allowance has an impact on ETR and can be quite a tricky, even subjective measure. So it really receives a lot of scrutiny from tax departments and external auditors.