Tax Accounting Minute – Deferred Tax Positive & Negative Evidence

Tax Accounting Minute

In this week’s episode of Tax Accounting Minute, our hosts discuss the importance of positive and negative evidence of deferred tax.

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Detailed Description of Tax Accounting Minute, Deferred Tax Positive & Negative Evidence

00:00:00
Robert: Hello, I’m Robert Henry. Welcome to our second edition of Tax Accounting Minute, where we talk all things ASC 740 and income tax accounting. Joining me again today is Deanna Johnson. Hello, Deanna.

00:00:15
Deanna: Hello.

00:00:16
Robert: And today we’re going to talk about sort of a continuation of our last topic involving the valuation of deferred tax assets and liabilities recorded on the financial statements. We went over the concept of what is a valuation allowance and how you may measure things in order to determine the appropriate amount of valuation allowance.

Well, when you go into that, there are weightings of evidence. And I think, Deanna, it’d be nice to talk through what different pieces of evidence are there saying we will use these deferred tax assets. What is some of the negative evidence and what weight is placed on each type of evidence?

00:00:54
Deanna: Yeah. The most important thing we probably didn’t discuss last time is the importance of positive and negative and putting it in the different buckets, how to weigh them against each other. The ASC 740 provides guidance generally that the weight given to positive and negative evidence should be commensurate with the extent to which it can be objectively verified. Sometimes the negative objectively verifiable evidence is so strong it can’t be overcome, and evaluation allowance against the net DTAs must be established.

For example, a recent history of losses would generally create such objectively verifiable negative evidence that it would be tough to overcome. So usually, a recent history of losses would necessitate a valuation allowance. If you don’t have a recent history of losses, then you have to start looking at other evidence that sometimes is less objectively verifiable, and it becomes this weighting exercise and a facts and circumstances decision.

00:01:53
Robert: Right. And so, when we get into the last objective, if you will, sort of forms of evidence like projections, how do those look, how do you use them? For instance, what level of weight is given to projections? And then two, when can you take certain projected items into account? We’ve got a planned transaction that will likely generate gain and income to the company, i.e., when can we take that into account when looking at projections of income?

00:02:24
Deanna: Sure. Okay. So, the first question is about projections of income and when you can take those into account. So, you sort of look at two different sources of income looking forward, right? Your reversals of your deferred tax liabilities, and then you can also look at projections of book income, which is basically your book plus perms. And when you want to take that into account, you really want to determine whether the company can effectively forecast and how effective their forecasts have been in the past. If they struggle to forecast, with any kind of accuracy or even relative accuracy, then you’re going to have a hard time adding a lot of weight to that, right? So, then you’re really just looking at your reversals of your deferred tax liabilities.

In terms of originating deferred tax liabilities, if you are taking into account your pre-tax book income at that point, then you can start looking at originating deferred tax liabilities and that comes into play also. So, there’s a lot of complexity that can go in there.

In terms of whether there’s a future sale in the works and whether you can take that into account, you really have to look at the probability of that future sale and your weighting exercise. One of the considerations is once the portion of the business to be sold is probable, it reaches the level of probable and is classified as held for sale, then the weight of the evidence is significant enough to be considered in the valuation allowance assessment.

00:03:55
Robert: I don’t want to put you on the spot, but what is probable? What does that mean? Do we have a signed letter of intent (LOI) or do we have a definition of probable?

00:04:05
Deanna: We need to look at the probability of the future sale as part of our weighting exercise. So once the portion of the business to be sold is probable and therefore classified as held for sale in the financial statements, the weight of the evidence is significant enough to be considered in the valuation allowance assessment as well.

00:04:24
Robert: So, it sounds like this whole business of projections and scheduling projections can get circular real fast, especially when you start looking at originating temporary differences in your projections, which means projecting and predicting what sort of timing differences will come up in the future. So, we want to stay out of that ballpark, right?

00:04:45
Deanna: Well, I would say it depends on how accurate their forecasts usually are. If their forecasts are usually accurate and you go back in time and look and see that their forecasts are relatively accurate, then it does add a little bit of weight to it to and it’s something that you can consider. If they’re really not in the ballpark, it’s probably something you want to stay away from if you can.

00:05:07
Robert: All right. Well Deanna, thank you for that. And as always, feel free to call us if you have any questions. Hopefully, this has been informative.

00:05:15
Deanna: Thank you.