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Tax toolkit: Valuation allowances, weighing the evidence · PwC's accounting podcast

• 0:00
  SPEAKER_00: Thought leadership from PWC.
• 0:09
  SPEAKER_02: Welcome to PWC's Accounting Podcast.
• 0:12
  SPEAKER_02: I'm Heather Horn.
• 0:14
  SPEAKER_02: Thanks for tuning in to our Toolkit series where we're taking a deep dive each month into a single topic, recapping the basics, but also focusing in on frequently asked questions and judgmental areas.
• 0:26
  SPEAKER_02: Today, we're wrapping up our discussion of income taxes.
• 0:31
  SPEAKER_02: This week, it's all about valuation allowances.
• 0:36
  SPEAKER_03: It's important to have a process in place to hit the new information because you got to get it in the right period.
• 0:43
  SPEAKER_01: The VA analysis, that's not something you want to save for the end.
• 0:47
  SPEAKER_01: A better approach would be to start the analysis early, even if you're using preliminary information.
• 0:54
  SPEAKER_02: My returning guests today are Jen Spang and Matt McCann, PWC National Office Partners.
• 0:59
  SPEAKER_02: They're going to take us through the sometimes challenging process of performing valuation allowance assessments in accordance with ASC 740.
• 1:08
  SPEAKER_02: I do have a very quick sidebar before we get started.
• 1:11
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• 1:18
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• 1:29
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• 1:37
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• 1:50
  SPEAKER_02: With that, let's turn to today's episode on valuation allowances.
• 2:01
  SPEAKER_02: Jen, Matt, thanks so much for joining me for another episode in our text toolkit.
• 2:06
  SPEAKER_02: And this is one I think can be challenging sometimes for some preparers in terms of thinking about when to use evaluation allowance, how to calculate, lots of different questions that we're going to run through today.
• 2:19
  SPEAKER_02: But before we get into some of the judgments in other areas, Matt, can you just start off by giving us an overview of what a valuation allowance is?
• 2:28
  SPEAKER_01: Yeah, sure, Heather.
• 2:29
  SPEAKER_01: So evaluation allowance for deferred tax assets, it's similar to an allowance for doubtful accounts for an account receivable.
• 2:37
  SPEAKER_01: When you have deferred tax assets that may provide a tax benefit in future years, but there's a question about the realizability, then you record the asset, but you may need to also provide a reserve against it.
• 2:50
  SPEAKER_01: So a valuation allowance is the reserve against the tax asset.
• 2:55
  SPEAKER_01: And just to give everyone a high-level overview of the model, so the income tax accounting standard, ASC 740, it requires that when the weight of all available evidence, and you have to look at everything, you know, both positive and negative evidence, when that leads you to conclude that it's more likely than not that a deferred tax asset will not be realized, then you record a valuation allowance against it.
• 3:22
  SPEAKER_01: And more likely than not, you know, that's a probability level of more than 50%.
• 3:27
  SPEAKER_01: But ultimately, the realization of deferred tax assets, it's going to depend on the existence of future taxable income.
• 3:34
  SPEAKER_02: So, Matt, just listening, obviously I've read this before, definitely makes sense for valuation allowances, but I think listening with the double negative, more likely than not that it will not be realized, can get confusing very quickly.
• 3:48
  SPEAKER_02: So is there another way that you would think about that?
• 3:51
  SPEAKER_01: Yeah, well, you have to evaluate whether it's more likely than not that the asset will be realized.
• 3:57
  SPEAKER_01: I mean, you can think about it that way as well.
• 3:58
  SPEAKER_01: And if if it's not, you know, then then you have to then you have to put up a valuation allowance.
• 4:04
  SPEAKER_01: But yeah, there's the the words, the words in the standard are are a little tricky.
• 4:08
  SPEAKER_02: All right.
• 4:08
  SPEAKER_02: Actually, even though you use the not again, I do like that.
• 4:11
  SPEAKER_02: So you're saying, is it more likely than not that it will be realized?
• 4:14
  SPEAKER_02: And if the answer is no, then you've considered the valuation allowance.
• 4:19
  SPEAKER_02: All right.
• 4:19
  SPEAKER_02: And for the listeners, Matt is nodding at me.
• 4:22
  SPEAKER_02: So it's I think I I think I got that right.
• 4:25
  SPEAKER_02: So thank you.
• 4:26
  SPEAKER_02: So then let me go on to my next question.
• 4:28
  SPEAKER_02: Does ASC 740 give you any guidance on how you would make that evaluation since there's not actually a scientific way to come up with that percentage as much as I think as accountants we'd like there to be?
• 4:40
  SPEAKER_01: It's uh it's definitely not scientific.
• 4:43
  SPEAKER_01: The uh the whole realizability analysis, it's it's subjective and requires a lot of judgment about weighing the positive and the negative evidence.
• 4:51
  SPEAKER_01: And the standard requires that evidence that's objectively verifiable that that carries more weight than evidence that that is not.
• 4:59
  SPEAKER_01: So what has already occurred and therefore can be objectively verified, that's gonna carry more weight than what may occur.
• 5:07
  SPEAKER_01: So, for example, you know, projections of of future income, those are those are not typically objectively verifiable, or at least some of the assumptions typically are not.
• 5:18
  SPEAKER_01: So you gotta think about, or the standard lays out four sources of income that can support the realization of deferred tax assets.
• 5:26
  SPEAKER_01: So I'll I'll list them out starting with the most objective.
• 5:30
  SPEAKER_01: So income in a carry back period, or the future reversal of taxable temporary differences or deferred tax liabilities, DTLs.
• 5:40
  SPEAKER_01: The first two, those are the those are the most objective.
• 5:43
  SPEAKER_01: And then the last two, they're getting into more subjective sources.
• 5:48
  SPEAKER_01: So you also have to think about tax planning strategies and projections of future income, excluding DTL reversals.
• 5:57
  SPEAKER_01: And 740 requires a company to consider each of the four potential sources of taxable income incrementally.
• 6:05
  SPEAKER_01: So if one source or two sources are sufficient, then you can you can stop there.
• 6:10
  SPEAKER_01: But if that's not the case, you gotta keep going until no incremental benefit can be can be realized.
• 6:17
  SPEAKER_01: And one thing I would point out is that an approach where a valuation allowance is determined by reference to a certain percentage of an entity's deferred tax assets, like you might you might see in an accounts receivable analysis, that's that's not gonna be appropriate under 740.
• 6:34
  SPEAKER_01: And then uh the last point I'll make is that sometimes the analysis indicates that a partial valuation allowance is warranted.
• 6:43
  SPEAKER_01: And when that's the case, you know, the whole analysis gets more challenging because it requires a higher degree of precision than if you were booking, you know, say a full VA or no VA.
• 6:54
  SPEAKER_01: So when you're when you're booking a partial valuation allowance, in most cases, the the amount of VA that you need, it's gonna need to be supported by a detailed scheduling of reversals of temporary differences.
• 7:07
  SPEAKER_02: So, Matt, I have a question about scheduling, but before we go on, I do have one question about something you said.
• 7:13
  SPEAKER_02: So you said if one or two sources are sufficient to realize the deferred tax assets, then you can stop.
• 7:19
  SPEAKER_02: And you had gone through the list of sort of most objective and getting to more subjective.
• 7:25
  SPEAKER_02: So, from a practical point of view, do people sort of follow that order when they are figuring out, or is that what we're going to get to when we start talking about scheduling?
• 7:37
  SPEAKER_01: Yeah, the standard doesn't prescribe any particular order, but probably makes sense to go ahead and start with what's most objective.
• 7:44
  SPEAKER_01: You know, if if you have those sources available, that's a little easier to evaluate.
• 7:49
  SPEAKER_01: And if you conclude, if you can conclude based on that, you're done.
• 7:53
  SPEAKER_01: But if you can't, you just gotta keep going until you hit all four sources.
• 7:58
  SPEAKER_02: All right.
• 7:59
  SPEAKER_02: And then definitely I do think it's interesting, and I know from personal experience can be challenging when you start talking about partial evaluation allowances.
• 8:07
  SPEAKER_02: And one of the things you mentioned there was this detailed scheduling of reversals of temporary differences.
• 8:13
  SPEAKER_02: So what can you share on that if if a listener is thinking about that type of scheduling?
• 8:20
  SPEAKER_01: Yeah, there's uh there's a couple points I would make on the scheduling topic.
• 8:25
  SPEAKER_01: And for first one being that detailed scheduling, it's not required by ASC 740, at least not in all cases, but it is necessary when it matters, meaning if it can have a significant impact on the analysis and the amount of VA that's required.
• 8:42
  SPEAKER_01: But how detailed of a scheduling analysis is required, that's going to be dictated by whether relatively minor shifts in the timing of taxable income, whether that's going to give you a materially different answer in terms of the amount of VA required.
• 8:57
  SPEAKER_01: So there's a a couple scenarios where that might be the case or where more detailed scheduling might be might be warranted.
• 9:04
  SPEAKER_01: First would be when the realization of the deferred tax asset depends only on future reversals of existing taxable temporary differences.
• 9:14
  SPEAKER_01: So let's say maybe you're in a net DTL position and reversals of DTLs are going to provide a source of income in the future when they reverse, but you still have to consider scheduling.
• 9:25
  SPEAKER_01: You could be in a situation where the DTLs reverse prior to the DTAs reversing, in which case the DTLs may not actually provide a source of income to realize those DTAs, and a VA would still be required.
• 9:38
  SPEAKER_01: Again, if if DTLs are the only source of income that's that's available.
• 9:42
  SPEAKER_01: So that's that's an important point.
• 9:44
  SPEAKER_01: May may come up a few times on the on the podcast.
• 9:48
  SPEAKER_01: But you may also be dealing with expiring tax attributes.
• 9:52
  SPEAKER_01: So in that case, some degree of scheduling is likely going to be necessary because reversals are going to impact the amount of income that's available in the period prior to the expiration of the of the attributes.
• 10:05
  SPEAKER_01: So I'd also point out that the 2017 Tax Cuts and Jobs Act introduced limitations on NOL usage as well as interest expense deductions, and that all of those limit limitations need to be factored into any scheduling analysis.
• 10:22
  SPEAKER_01: So just from those points alone, I mean you can see it doesn't take much for scheduling to get complicated, and it's not always uh an intuitive exercise.
• 10:32
  SPEAKER_01: So it's important to start the analysis early.
• 10:35
  SPEAKER_02: All right, definitely think that's a good reminder.
• 10:37
  SPEAKER_02: So, Jen, let me bring you into a conversation with a question that's maybe more on the judgmental side.
• 10:44
  SPEAKER_02: Because I know when we're thinking about evaluation allowance or whether evaluation allowance is needed, the standard says that the existence of cumulative losses in recent years is difficult to overcome.
• 10:56
  SPEAKER_02: And in terms of whether or not concluding whether or not you need evaluation allowance, so what do they mean when they say recent years?
• 11:05
  SPEAKER_03: Yeah, so the standard um doesn't define recent years, and it doesn't even define cumulative losses.
• 11:12
  SPEAKER_03: So generally, what companies look at is a three-year period.
• 11:16
  SPEAKER_03: So the current year and the prior two years when you're thinking about cumulative losses.
• 11:22
  SPEAKER_03: So that that would be, I guess, a pretty standard approach.
• 11:27
  SPEAKER_03: But I you do look at it, not only am I in a cumulative loss today, but do I expect to be in a cumulative loss?
• 11:35
  SPEAKER_03: So if you imagine you could be in a cumulative loss today, but you have a very profitable year, let's say that third, that second year back, that year is going to drop off.
• 11:45
  SPEAKER_03: Just mathematically, if you're looking at three years, you're adding in, let's say, a new year where maybe you're break-even.
• 11:52
  SPEAKER_03: In that case, you might not be in a cumulative loss today, but you could be moving into one.
• 11:57
  SPEAKER_03: And because of what Matt was talking about earlier on all available evidence, you really have to think about not just the moment you're in, but what is more likely than not, you know, what is objective about where you're going as well.
• 12:09
  SPEAKER_03: Um, so I think, you know, a couple of other things about cumulative losses.
• 12:14
  SPEAKER_03: So normally it is uh cumulative losses or income for that matter, would be your pre-tax income adjusted for permanent items.
• 12:23
  SPEAKER_03: But it is important to keep in mind that should also include things like discontinued operations, you might have OCI.
• 12:29
  SPEAKER_03: So you do need to look at, you know, the the um the organization, I guess I'd say comprehensively.
• 12:36
  SPEAKER_03: And then the last thing I would just say, and this is probably the most important thing, is just cumulative losses or income for that matter, are not a bright line test.
• 12:46
  SPEAKER_03: You could have cumulative income and still need a valuation allowance the same way as you could have a cumulative loss and not need a valuation allowance.
• 12:55
  SPEAKER_03: So I just can't stress enough, it is one piece of all available evidence that needs to be considered.
• 13:03
  SPEAKER_02: And Jen, one question on that, because when Matt was talking, he was talking about these four sources of income.
• 13:09
  SPEAKER_02: So if I'm in a situation where I do have cumulative losses, but I either have income in a carryback period or maybe more likely future reversal of tax temporary differences, then those may be things to think about that could overcome this presumption.
• 13:25
  SPEAKER_02: Is that a fair summary?
• 13:27
  SPEAKER_03: Very fair summary and absolutely accurate because your carry back is just do you have it under the law or do you not?
• 13:33
  SPEAKER_03: And then your deferred tax liabilities, you have to consider.
• 13:36
  SPEAKER_03: So sometimes companies have gotten a little bit tripped up where they can see that they're or they might be projecting losses going forward.
• 13:44
  SPEAKER_03: So when they think about those deferred tax liabilities, they're just going to reverse into a future loss.
• 13:49
  SPEAKER_03: So in their minds, they might say, oh, well, that must not be a source for today's income or sorry, for today's deferred tax assets.
• 13:57
  SPEAKER_03: And in fact, that would not be accurate.
• 13:59
  SPEAKER_03: You have to consider those deferred tax liabilities.
• 14:02
  SPEAKER_03: So what you said is absolutely true.
• 14:04
  SPEAKER_02: All right.
• 14:05
  SPEAKER_02: But the key point there is if you're in that situation where you have cumulative losses, then it is going to be important to do scheduling, to think through all of these different pieces and to make sure you do have evidence if you're not going planning to record evaluation allowance.
• 14:21
  SPEAKER_02: Or I guess either way, you probably need to make sure you have evidence and documentation.
• 14:26
  SPEAKER_03: Absolutely right.
• 14:26
  SPEAKER_03: And again, keep in mind when you're thinking about those cumulative, either an income or loss position, what you're generally doing is getting ready to think about your forecasts as one of your sources.
• 14:37
  SPEAKER_03: And tax planning is just another level of that.
• 14:41
  SPEAKER_03: So once you're starting to be in that place, you're oftentimes thinking about you're trying to say, well, geez, I had losses in the past, but I want to project income going forward.
• 14:51
  SPEAKER_03: And you're trying to maybe bridge that gap.
• 14:54
  SPEAKER_02: All right, very helpful.
• 14:55
  SPEAKER_02: One more question is that Matt mentioned and stressed that you have to consider all available evidence when you're considering whether or not you need evaluation allowance.
• 15:05
  SPEAKER_02: How does subsequent events fit into that?
• 15:07
  SPEAKER_03: That's a great question.
• 15:08
  SPEAKER_03: It comes up a lot.
• 15:10
  SPEAKER_03: All available evidence does sweep in subsequent events, but I would say not all subsequent events are created equal.
• 15:19
  SPEAKER_03: So all available, we at least don't think all available evidence, for example, would sweep in something like an IPO or a business combination.
• 15:28
  SPEAKER_03: Those are accounted for in the period.
• 15:30
  SPEAKER_03: Similarly, you know, um, some kind of a natural disaster.
• 15:35
  SPEAKER_03: So, you know, that seems too far when you're thinking about all available evidence at the balance sheet date.
• 15:41
  SPEAKER_03: But you could have events that are non-recognized from otherwise pre-tax basis, uh, non-recognized subsequent event that you would factor in to your, let's say your, you know, all available evidence in assessing that need or um the need for either AVA or the amount of one.
• 16:00
  SPEAKER_02: All right, very helpful.
• 16:01
  SPEAKER_02: So then, Matt, let me go back to you and let's dig in a little bit more to those four sources of income.
• 16:08
  SPEAKER_02: So for this discussion, let's assume I have I do conclude I have significant negative evidence because I have three years of cumulative losses and working on my Val allowance analysis.
• 16:21
  SPEAKER_02: So as we think about those four sources of income, I know I summarized them a bit when I was talking to Jen, but let's let's dig in.
• 16:28
  SPEAKER_02: So, first, starting with projections, since recent losses are highly objective, can projections alone ever be sufficient to overcome this negative evidence?
• 16:40
  SPEAKER_01: Yeah, that's another fairly common question that we get.
• 16:43
  SPEAKER_01: And they can, but it can be challenging to rely on this on this source of income.
• 16:49
  SPEAKER_01: So when you're talking about projections, you know, that's that's what management is going to be using for a whole variety of purposes.
• 16:55
  SPEAKER_01: You know, they may be sharing it with the board, they may be using it for goodwill impairment analysis, it's going to reflect what management projects their future earnings will be.
• 17:06
  SPEAKER_01: And they're inherently going to include various assumptions and estimates.
• 17:11
  SPEAKER_01: And while it is important to keep in mind that there should be consistency in the forecast used throughout the financial statements, what works for a goodwill impairment analysis might not work for a VA analysis because of the 740 requirement to assign the most weight to what can be objectively verified.
• 17:30
  SPEAKER_01: So this results in a higher bar to avoid evaluation allowance than some of the other asset impairment models.
• 17:38
  SPEAKER_01: And because of the inherent subjectivity, a lot of times it's it's difficult to bridge management's forecast to a forecast of future taxable income that could be considered objectively verifiable.
• 17:51
  SPEAKER_01: So you do need to consider historical results, but you also need to think about what might now be different and is it objectively verifiable to be able to justify differences between the past and projections of the future.
• 18:05
  SPEAKER_01: So I give you an example.
• 18:07
  SPEAKER_01: Just consider a fact pattern where a company recently paid down a large amount of debt and doesn't expect to need similar debt in the future.
• 18:15
  SPEAKER_01: And the interest on the old debt may have contributed to historical losses.
• 18:20
  SPEAKER_01: But since it no longer exists, you know, clearly the future is going to look different than the past.
• 18:24
  SPEAKER_01: And in this case, the pay down of debt, I mean it's factual and verifiable.
• 18:29
  SPEAKER_01: So in this example, it would make sense to consider what the future will look like starting with the baseline of the recent year adjusted for the reduction in interest expense.
• 18:40
  SPEAKER_01: And if nothing else changed, you know, will the business be profitable after taking into account the reduction in interest expense?
• 18:47
  SPEAKER_01: So the answer to that type of question or to this to this question, that'll help bridge the gap between historical results and an objectively verifiable forecast.
• 18:58
  SPEAKER_02: All right.
• 18:58
  SPEAKER_02: So it's definitely a very clear example, and I think a good one.
• 19:02
  SPEAKER_02: However, I think maybe more often there's a tendency when you're forecasting to sort of normalize events that you shouldn't, or perhaps, you know, you have a history of losses, there's nothing objectively verifiable that's changing, but yet you think things are going to turn around.
• 19:19
  SPEAKER_02: So how do you sort of think about that?
• 19:21
  SPEAKER_01: Yeah, that's that's definitely the case.
• 19:23
  SPEAKER_01: We we do see that all the time.
• 19:25
  SPEAKER_01: But I I would just say there there needs to be a really critical assessment of what can be demonstrated to be objectively verifiable.
• 19:33
  SPEAKER_01: So my my debt example, you know, that's that's a straightforward example, but one that is objectively verifiable once the once the debt has been paid down.
• 19:43
  SPEAKER_01: But two areas that tend to generate a fair bit of debate are restructuring charges and goodwill impairments, both of which could cause large losses in in recent years.
• 19:54
  SPEAKER_01: So there are instances where a company may be able to demonstrate that the cost will not recur, but there's probably as many, if not more, instances where companies aren't able to demonstrate this, given for a lot of companies, the history of such items occurring on on multiple occasions in the past will limit the ability to say you know it's not it's not going to happen in the future.
• 20:17
  SPEAKER_02: Right.
• 20:17
  SPEAKER_02: And I'm guessing, Matt, even if that's just a one-time event, you still really need to evaluate.
• 20:23
  SPEAKER_02: If you have that, you can't just presume that your future looks bright.
• 20:28
  SPEAKER_01: Yeah, that's right.
• 20:29
  SPEAKER_01: We're usually pretty skeptical about those items, especially, you know, like I said, if there is a a history of of those types of one-off events occurring occasionally in the in the past.
• 20:41
  SPEAKER_02: All right, so Matt's super helpful.
• 20:43
  SPEAKER_02: So any other pitfalls that we should think about when we're looking at projections?
• 20:48
  SPEAKER_01: Yeah, a couple of things I would point out, Heather, and maybe a few of these points I have in mind are broader than just projections.
• 20:56
  SPEAKER_01: But first thing I'd I'd reiterate are just the points we've been talking about around objectively verifiable and advise companies to be very cautious when considering the weight they give to projected growth.
• 21:09
  SPEAKER_01: Any favorable improvements in profitability based on assumed growth rates or the effects of a recently completed acquisition, for example, should be approached with a fairly high degree of skepticism of again, if they can't be objectively verified, generally very little weight can be given to the effects of projected growth until the growth is actually demonstrated in the results.
• 21:35
  SPEAKER_02: Or Matt, I guess as I was thinking about this, if I have a signed contract with a new customer, that could that be objectively verifiable versus I'm hoping to sign a contract with a new customer?
• 21:49
  SPEAKER_01: Yeah, that'd be that'd be a good example of something that uh you could you could take into account that meets the meets that criteria.
• 21:56
  SPEAKER_02: All right.
• 21:56
  SPEAKER_02: It sounds like though the signature is going to be very important since you've said.
• 22:00
  SPEAKER_02: Objectively verifiable.
• 22:01
  SPEAKER_02: I wasn't counting, but I think it's definitely at least more than 10, if not 20 times in the past couple minutes.
• 22:08
  SPEAKER_03: Although, maybe one thing to think about that, Heather, I agree with Matt, that would definitely be something that could be objectively verifiable, but you also need to figure out that that contract will result in positive margins, right?
• 22:20
  SPEAKER_03: So yes, fair point.
• 22:22
  SPEAKER_03: Very good point.
• 22:23
  SPEAKER_03: Yeah, so but it but it is clearly a piece of evidence.
• 22:26
  SPEAKER_03: I agree with Matt that that is objective.
• 22:29
  SPEAKER_03: So you sure you surely should be at least thinking about it.
• 22:32
  SPEAKER_03: But then what evidence do you have on the on the right?
• 22:35
  SPEAKER_03: That you're actually going to make money from this contract is the key point.
• 22:38
  SPEAKER_02: All right, very good.
• 22:39
  SPEAKER_02: So, Matt, you said you had a couple of things to point out, and I jumped in after the first one.
• 22:44
  SPEAKER_02: So any other things we should be thinking about here?
• 22:47
  SPEAKER_01: Yeah, a couple other ones, and maybe uh maybe the next one's just kind of reiterating one of one of Jen's earlier point.
• 22:54
  SPEAKER_01: If if you get into a situation you where you're projecting to continue accumulating carry forwards into the foreseeable future, you still have to take into account DTLs as a source of income.
• 23:07
  SPEAKER_01: And scheduling might come into play, but assuming that there's no issues with scheduling, DTLs kind of set the floor in terms of the amount of income that needs to be considered in the analysis.
• 23:17
  SPEAKER_01: You know, going back to what we've been talking about is in terms of having to look at each source of income individually.
• 23:24
  SPEAKER_01: We also uh we also sometimes see companies anticipating the effects of expected tax law changes in their VA analysis.
• 23:33
  SPEAKER_01: There's a whole host of potential tax law changes on the on the horizon, both here in the US and globally, but it's important to remember the impacts of any tax law changes should be considered only for enacted changes.
• 23:46
  SPEAKER_01: And then the last the last point I'll make is that Sum 40 requires that the VA analysis be done jurisdiction by jurisdiction.
• 23:55
  SPEAKER_01: So you don't want to underestimate the amount of work involved to evaluate all available evidence and reach separate conclusions for each jurisdiction that a company operates in.
• 24:05
  SPEAKER_02: All right, that's definitely helpful.
• 24:07
  SPEAKER_02: So, Jen, let's go to another topic where I also think there's a lot of judgment involved, and one that, again, I personally find complicated often to think about, and that would be the use of tax planning strategies.
• 24:20
  SPEAKER_02: So, how can you think about those as positive evidence?
• 24:24
  SPEAKER_03: Yeah, so I think first it's important to look at the standard to see what the standard tells us it is, right?
• 24:31
  SPEAKER_03: So a tax planning strategy is something that the standard provides for, and it's something that management might not do, but they will do in order to prevent an asset from expiring.
• 24:45
  SPEAKER_03: The standard goes on to say, though, that it needs to be both prudent and feasible.
• 24:50
  SPEAKER_03: So I think there's a few things within those two sentences that we need to think about.
• 24:54
  SPEAKER_03: So, first, what is prudent and feasible?
• 24:57
  SPEAKER_03: Well, feasible is can I do it?
• 24:59
  SPEAKER_03: Uh right.
• 25:00
  SPEAKER_03: So is it primarily in management's control?
• 25:02
  SPEAKER_03: If it's something that depends, let's say, on a future market or a third party that management doesn't control, then you you got to question whether you really can do it.
• 25:13
  SPEAKER_03: And then prudent doesn't make sense.
• 25:15
  SPEAKER_03: You know, it's like the old saying, um, just because you can doesn't mean you should.
• 25:20
  SPEAKER_03: Um, so so prudent is really does it make sense for the company?
• 25:25
  SPEAKER_03: So there's an awful lot of things you can do, but it wouldn't necessarily be in the best interest of the company.
• 25:32
  SPEAKER_03: So prudent is really pushing and testing on that.
• 25:34
  SPEAKER_03: I guess what I would say, the other thing I mentioned at the beginning of what the standard tells us is the definition of a tax planning strategy.
• 25:43
  SPEAKER_03: It says it's something that the company would do to prevent an asset from expiring.
• 25:48
  SPEAKER_03: So Matt mentioned early, earlier, uh I think indefinite carry forwards or having a definite life.
• 25:55
  SPEAKER_03: Today's world, we're looking at a lot of assets that have an indefinite life.
• 26:00
  SPEAKER_03: If you're thinking about that, it never expires.
• 26:03
  SPEAKER_03: So you really have to question whether tax planning strategies are really can be used in that setting.
• 26:09
  SPEAKER_03: But there, I would just go back.
• 26:11
  SPEAKER_03: I suppose one theme that will come away from the podcast is this word objectively verifiable.
• 26:18
  SPEAKER_03: But um, while tax planning strategies may not be looked at when you're thinking about an indefinite carry forward, you could think about a tax action that is already under in play.
• 26:30
  SPEAKER_03: So something that the company is already doing, they've built into the forecast, it's obviously happening, so it's objective.
• 26:38
  SPEAKER_03: So it just because you can't look at a tax planning strategy doesn't mean that you would ignore something that is in progress.
• 26:45
  SPEAKER_03: I think one thing to just keep in mind the difference between, let's just say, a tax planning strategy and just a tax action.
• 26:53
  SPEAKER_03: You know, in a tax planning strategy, it's something that a company would do.
• 26:58
  SPEAKER_03: So they don't need to do it today.
• 27:00
  SPEAKER_03: 20 years from now, they could say, well, we'll do it in 20 years from now.
• 27:04
  SPEAKER_03: The problem is that if you have an indefinite live, there's no trigger for you having to do it.
• 27:10
  SPEAKER_03: And so, how do you get over that objectively verifiable threshold in that case?
• 27:15
  SPEAKER_03: So lots of factors to think about there in tax planning.
• 27:18
  SPEAKER_02: And Jen, your point on that last one is that if it's something that you like are going to do in 20 years, is that really supporting not use, not recording evaluation allowance today?
• 27:30
  SPEAKER_03: So it is if you're talking about a tax planning strategy, as long as management can say, um, I will do it prior to that expiration.
• 27:40
  SPEAKER_03: But take, for instance, um, think of an example like I have an asset that has an appreciated value, and it is not a part of my core business.
• 27:51
  SPEAKER_03: And so my strategy is I will sell that prior to my asset expiring.
• 27:57
  SPEAKER_03: So now, good enough, that can be a good tax planning strategy.
• 28:01
  SPEAKER_03: It's not core to your business, so it's prudent, right?
• 28:03
  SPEAKER_03: You've you've got um assets that could cover the tax on it.
• 28:07
  SPEAKER_03: So again, it's prudent.
• 28:08
  SPEAKER_03: But what you have to ask yourself when you're looking into that is well, if my asset doesn't expire for 20 years, what is objective about the appreciation 20 years from now?
• 28:20
  SPEAKER_03: So it doesn't mean you won't use it, it just means now you're even in a tax planning strategy, you've got to think about what is the evidence around that being objectively verifiable, versus let's imagine your attribute will expire in only three years.
• 28:34
  SPEAKER_03: Right.
• 28:35
  SPEAKER_03: And let's imagine that asset has had that same appreciated value for the last five years, right?
• 28:40
  SPEAKER_03: You start to layer those factors in.
• 28:42
  SPEAKER_03: And to your, I think your original question, there's judgment, right?
• 28:46
  SPEAKER_03: So there is there is judgment.
• 28:48
  SPEAKER_02: Well, and I think key point of what you just talked about is that important element of this when you're thinking about tax planning or a tax planning strategy is you really have to understand the full impact on your entity.
• 29:01
  SPEAKER_02: No question.
• 29:02
  SPEAKER_03: And and that is a I think a critical point because a lot of what we talk about are intercompany transactions, right?
• 29:10
  SPEAKER_03: Because those are within a company's control.
• 29:12
  SPEAKER_03: But when you're thinking about whether or not you need a valuation allowance and you're thinking about prudence, you really need to be looking at your total company impact of that from a cash tax savings, right?
• 29:26
  SPEAKER_03: So if you, for example, have losses in a jurisdiction, um, a high-tax jurisdiction, and you have an asset in a low-tax jurisdiction that's generating income, you clearly could, it's all inner company, you could sell that asset to the loss jurisdiction and then start to generate income in that jurisdiction and use up the NOL.
• 29:50
  SPEAKER_03: The problem is that you know you were paying zero tax before because you had a low tax jurisdiction and you had a loss.
• 29:56
  SPEAKER_03: Now you just put an asset into a high-tax jurisdiction and you'll still be paying tax after you finish using the loss.
• 30:02
  SPEAKER_03: So that's where you start to get into does that make economic sense, right?
• 30:06
  SPEAKER_03: Is that prudent?
• 30:08
  SPEAKER_03: And so um you're a hundred percent correct that you can't just think about one side of the transaction.
• 30:13
  SPEAKER_03: You have to think about the impact to the company.
• 30:16
  SPEAKER_02: So, Jen, let me ask you a question going back to feasible.
• 30:19
  SPEAKER_02: And I think this top of mind because we've been talking about uncertain tax positions on the podcast.
• 30:25
  SPEAKER_02: And it seems like when you're thinking about a strategy and thinking about feasible, this may also bump up against maybe actions you're going to take that may or may not be sustained by the IRS.
• 30:38
  SPEAKER_02: So there could be an intersection there as well with uncertain tax positions.
• 30:44
  SPEAKER_02: Perhaps you can articulate that better than I just did, but uh I think there's an interaction there.
• 30:50
  SPEAKER_03: Yeah, no, I think you articulated it perfectly.
• 30:52
  SPEAKER_03: Um it's the IRS and the government on the other side, or any governments that you're dealing with.
• 30:58
  SPEAKER_03: Any of these tax planning strategies, in order to be something you would even consider as a source of future taxable income, needs to have met that more likely than not recognition and measurement threshold that we've talked about on uncertain tax positions.
• 31:12
  SPEAKER_03: So, no, it's a great point.
• 31:14
  SPEAKER_03: It's actually very important to be keeping that in mind whenever you're thinking about, frankly, any of these positions or any of these sources, they all need to be at that more likely than that level.
• 31:25
  SPEAKER_02: All right, so it's very helpful.
• 31:27
  SPEAKER_02: So then before we actually get into reversals evaluation allowance, which obviously would be good news for the company that recorded it, Jen, any other misconceptions that you would highlight when you're evaluating management's valuation allowance assessments?
• 31:42
  SPEAKER_03: Yeah, I think there's probably two that I'd add to uh what Matt shared earlier.
• 31:47
  SPEAKER_03: One is actually what we just talked about under tax planning strategies and this idea of incremental tax savings when you asked about looking at that enterprise-wide.
• 31:58
  SPEAKER_03: There's another avenue of that that comes up, which is about substitution.
• 32:02
  SPEAKER_03: So still focusing on that incremental benefit or savings, if you will.
• 32:08
  SPEAKER_03: So substitution is really as simple as I've taken one deferred tax asset and replaced it with another.
• 32:15
  SPEAKER_03: Simplest way to understand this is through an example.
• 32:18
  SPEAKER_03: So just imagine that under the duress in the jurisdiction you're in, you have under the law the ability to capitalize RD expenses.
• 32:27
  SPEAKER_03: And let's further imagine you have a loss carry forward that's going to expire.
• 32:32
  SPEAKER_03: So you could um capitalize that RD expense, generate taxable income.
• 32:40
  SPEAKER_03: So that RD expense has just become another deferred tax asset, while you just consumed, and I'm using the word consumed, um, the NOL carry forward.
• 32:51
  SPEAKER_03: So you just flipped one asset for another.
• 32:54
  SPEAKER_03: In a valuation allowance setting, pure substitution, you didn't actually realize the benefit of an asset.
• 33:00
  SPEAKER_03: You just replaced it with a new one.
• 33:02
  SPEAKER_03: You used it up in a tax law setting.
• 33:05
  SPEAKER_03: You you used it up, it got used on a return, but you just replaced it with another asset.
• 33:10
  SPEAKER_03: Now, substitution can actually be a good thing if you've actually returned to an objective level of profitability such that now that new asset is going to have a longer tail and you'll have more time to get enough income to realize the asset.
• 33:27
  SPEAKER_03: So in that case, it can be great.
• 33:29
  SPEAKER_03: But if you at your core are still in, let's say, a cumulative loss position, you've just simply exchanged one asset for another, but you still don't have that objective source of future taxable income.
• 33:43
  SPEAKER_03: So substitution is another one of those incremental savings.
• 33:48
  SPEAKER_03: And then I just uh we probably, as much as we mentioned objectively verifiable, we're probably mentioning deferred tax liabilities.
• 33:56
  SPEAKER_03: So I'll maybe add one more to Matt's list on deferred tax liabilities.
• 34:02
  SPEAKER_03: And that deals with, you know, when you have this indefinite live deferred tax liability and making sure you're scheduling to the extent that you have an indefinite live deferred tax liability.
• 34:15
  SPEAKER_03: So think of like a deferred tax liability on in an indefinite live intangible or goodwill.
• 34:22
  SPEAKER_03: So you have a deferred tax liability, but its reversal is based upon either impairment, impairment, or sale.
• 34:30
  SPEAKER_03: And so if that's the case, you may not be able to use that deferred tax liability, as Matt mentioned, against deferred tax assets that exist today, except.
• 34:39
  SPEAKER_03: So this is, I'm just adding the accept part.
• 34:42
  SPEAKER_03: If your deferred tax asset is also indefinite in nature, so think about an NOL that doesn't expire.
• 34:50
  SPEAKER_03: Now that deferred tax liability that we refer to as a naked credit, it could be a source against an indefinite live deferred tax asset.
• 34:59
  SPEAKER_03: We've seen that come up a lot in the US jurisdiction since the change in tax law back in late 2017.
• 35:07
  SPEAKER_03: So I just really stressed that one.
• 35:10
  SPEAKER_03: It's really just reiterating what Matt said before.
• 35:12
  SPEAKER_03: You really have to pay attention to scheduling and what the specific attributes are that you're looking at.
• 35:19
  SPEAKER_02: So then, Jen, how do you think about the need for evaluation allowance when you have these indefinite live DTAs?
• 35:25
  SPEAKER_02: Do you even have to think about it because it's never going to expire?
• 35:28
  SPEAKER_03: Maybe I should have added that as a third common misconception.
• 35:32
  SPEAKER_03: Yeah.
• 35:32
  SPEAKER_03: So you do, because again, you have to have some source, even though it's indefinite.
• 35:39
  SPEAKER_03: And often what we'll hear is, well, of course I'll make money someday.
• 35:43
  SPEAKER_03: Like I know that I will.
• 35:44
  SPEAKER_03: And so that's all fair, except that the standard requires that you have an objectively verifiable source of future taxable income.
• 35:53
  SPEAKER_03: So even in an indefinite jurisdiction, you need that$1 revenue to start using up that, those carry-forwards.
• 36:00
  SPEAKER_03: So even in those cases, you do have to hit that same objective, um objectively verifiable level to be able to start realizing that asset.
• 36:07
  SPEAKER_02: All right.
• 36:08
  SPEAKER_02: I think you may have even said that more times than that.
• 36:10
  SPEAKER_02: I should have been counting when we started.
• 36:12
  SPEAKER_02: So very helpful and very good reminders there.
• 36:15
  SPEAKER_02: So now let's go to something that I think is uh the more positive part of this discussion, which would be when you get to actually start reversing your evaluation allowances.
• 36:25
  SPEAKER_02: So, Matt, how do we think about whether or not it's the right time to record a reversal?
• 36:33
  SPEAKER_01: Yeah, and really, really the assessment is the same as everything we've been we've been talking about.
• 36:38
  SPEAKER_01: The question is still whether the tax assets are more likely than not to be recovered.
• 36:44
  SPEAKER_01: So if the weight of the evidence in a period changes, such that the answer to the answer to that question changes, and the answer is yes now, then you would be in a position to release a valuation allowance.
• 36:56
  SPEAKER_01: But you know, like everything we've been talking about, a lot of subjectivity, a lot of judgment.
• 37:00
  SPEAKER_01: So companies really need to be prepared to answer the answer the question of why this quarter, you know, why not last quarter, or why not, why not next quarter?
• 37:10
  SPEAKER_01: So lots of judgment involved, and this this is an area that the SEC tends to tends to ask about as well.
• 37:17
  SPEAKER_01: So you want to make sure that there's clear, explainable reasons, you know, whether that's a quantitative analysis or qualitative or most likely a combination of both, you you want to be able to point to something that that triggers the change in judgment or that modifies the the previous judgment.
• 37:36
  SPEAKER_01: And it makes it really important to document the judgments made in the analysis on a real-time basis and to provide early warning disclosures of potential VA changes.
• 37:47
  SPEAKER_01: This is an area when we talk about changes that we do tend to see a lot of a lot of activity in the fourth quarter.
• 37:53
  SPEAKER_01: But I would I would point out, or it's important to remember, it's it's not an annual assessment or a trigger-based assessment like you see with other impairment models.
• 38:02
  SPEAKER_01: If you have DTAs, that's again regardless of if you're in a net DTL position, then you are required to do an analysis at the end of each reporting period.
• 38:12
  SPEAKER_02: All right, good reminder, and uh documentation disclosure, I think, are always good reminders.
• 38:17
  SPEAKER_02: So, how about so the that was just talking about reversal, but how about changes, evaluation allowance, anything specific we should be thinking about?
• 38:25
  SPEAKER_03: Yeah, so I think let me jump in here.
• 38:28
  SPEAKER_03: I I think the question that comes up around changes is in any given period that you have a change, how do you record it?
• 38:36
  SPEAKER_03: And I think when people are asking that, they're really asking two different questions.
• 38:39
  SPEAKER_03: One is do you record it discreetly or as part of your annual effective tax rate?
• 38:44
  SPEAKER_03: And then the second question is, where do you report it?
• 38:47
  SPEAKER_03: Um, so interperiod allocation is really just the concept and the standard of allocating your total provision to the different components, being like continued ops, continuing ops, discontinued ops, OCI, et cetera.
• 39:00
  SPEAKER_03: So when I think about those two questions, and this is whether this is sort of no matter what that change is, but we usually talk about it in the context of a release.
• 39:10
  SPEAKER_03: Um, generally speaking, a change in your beginning of your balance is going to be accounted for discreetly.
• 39:16
  SPEAKER_03: Now, you'll hear me say generally a few times here, my guess.
• 39:20
  SPEAKER_03: Um, so generally a change on your beginning balance is going to be discrete.
• 39:25
  SPEAKER_03: It is also generally going to be reported in continuing operations.
• 39:30
  SPEAKER_03: And both of those are because the standard tells us so.
• 39:33
  SPEAKER_03: Um, but I just maybe a few caveats to the extent, or I guess a few elaborations, to the extent that you have a change that's because of the current year.
• 39:43
  SPEAKER_03: So let's imagine that you are releasing a valuation allowance in the current year because of current year income.
• 39:52
  SPEAKER_03: That is generally going to go through normal intra periods.
• 39:56
  SPEAKER_03: So meaning it's going to get allocated in the normal with and without method, and it's probably going to go through your annual effective tax rate.
• 40:04
  SPEAKER_03: But generally, if it's for the impact is something other than the current year, it will be accounted for discreetly because it's not part of ordinary income in the current year.
• 40:17
  SPEAKER_03: So there's a few things to think about there, but hopefully some of that general guidance will help.
• 40:22
  SPEAKER_03: Yes, definitely very helpful.
• 40:24
  SPEAKER_02: Let me go back actually, Matt, to you.
• 40:26
  SPEAKER_02: So you mentioned disclosure.
• 40:27
  SPEAKER_02: So I said it was always a good reminder.
• 40:29
  SPEAKER_02: But anything specific that people should be thinking about from a disclosure perspective when you're talking about valuation allowances?
• 40:36
  SPEAKER_01: Yeah, there's there's actually not a whole lot of detailed disclosure guidance in ASC 740 itself.
• 40:42
  SPEAKER_01: You know, the standard does require that companies disclose the total valuation allowance and the net change in the valuation allowance for each period a balance sheet is is presented.
• 40:53
  SPEAKER_01: But there's some other disclosure guidance if you look more broadly than just 740.
• 40:58
  SPEAKER_01: So companies should also consider ASC 275 that requires disclosure of certain significant estimates that affect the carrying amount of assets and liabilities based on the facts and circumstances existing at the date of the financials.
• 41:14
  SPEAKER_01: And so also disclose how that how these estimates may be particularly sensitive to changes in the in the near term.
• 41:21
  SPEAKER_01: And so that that would include valuation allowances.
• 41:25
  SPEAKER_01: But then, as I mentioned before, the SEC has also commented in this area on a pretty regular regular basis, and they they've emphasized the need to provide disclosures regarding the relevant positive and negative factors that were considered when assessing the realization of deferred tax assets, things like sustained pre-tax profitability or just other other key assumptions supporting the analysis.
• 41:51
  SPEAKER_01: And again, they do they do expect companies to give forewarning regarding any future valuation allowance increase or decrease.
• 42:00
  SPEAKER_02: All right, definitely good reminders there.
• 42:02
  SPEAKER_02: So I preface this whole podcast by saying this is a lot of judgment involved, and I think you guys supported that through our conversation.
• 42:10
  SPEAKER_02: We covered a lot of ground here.
• 42:12
  SPEAKER_02: So final takeaways, I guess, Matt, if there's like one piece of advice you could give, what would it be?
• 42:18
  SPEAKER_01: Yeah, I think I would highlight again just the amount of work involved to gather all available evidence, analyze the four sources of income, which may include a detailed scheduling analysis, and doing all this by jurisdiction.
• 42:32
  SPEAKER_01: So finalizing the tax provision sometimes is done near the end of a company's closing process, but the the VA analysis, that's not something you want to save for the end.
• 42:42
  SPEAKER_01: A better approach would be to start the analysis early, even if you're using preliminary information.
• 42:48
  SPEAKER_02: All right.
• 42:49
  SPEAKER_02: And Jen, how about from your perspective?
• 42:51
  SPEAKER_03: Well, I'm gonna sneak two in, but they're related.
• 42:54
  SPEAKER_03: Um, one is just it's important to have a process in place to hit the new information because you got to get it in the right period, as Matt mentioned earlier.
• 43:04
  SPEAKER_03: Well, we see a lot of the activity at year end, it's a balance sheet by balance sheet um uh period analysis.
• 43:12
  SPEAKER_03: It shouldn't always wait to the end of the year.
• 43:14
  SPEAKER_03: But closely aligned to that is just scheduling, I think, has become a reality for many companies.
• 43:20
  SPEAKER_03: And so um it's probably just to not underestimate what needs to go into that scheduling process.
• 43:26
  SPEAKER_02: All right, good reminders.
• 43:28
  SPEAKER_02: So, as always, I appreciate all the insight.
• 43:30
  SPEAKER_02: One more thing before you go.
• 43:32
  SPEAKER_02: I know it's this favorite part.
• 43:33
  SPEAKER_02: I'm gonna try to stump you guys again.
• 43:35
  SPEAKER_02: I we'll see what you think of these questions.
• 43:38
  SPEAKER_02: I do have hints for them, so if if that helps.
• 43:42
  SPEAKER_02: So, first one is who was president the year that FAS 109 was effective?
• 43:48
  SPEAKER_02: And I'm happy to give a hint if you would like a reminder of when that was.
• 43:53
  SPEAKER_01: And please.
• 43:54
  SPEAKER_02: So it was effective for years beginning after December 15th, 1992.
• 44:00
  SPEAKER_02: So 20, wait, 30 years.
• 44:06
  SPEAKER_02: So there you go.
• 44:07
  SPEAKER_02: So you get half a point there, Jen.
• 44:09
  SPEAKER_02: All right.
• 44:10
  SPEAKER_02: So any guesses on who was president in 19, I guess that would have been 1993, basically, or 1992.
• 44:16
  SPEAKER_01: I'm gonna go with Reagan.
• 44:18
  SPEAKER_02: Oh, Jen, any guesses?
• 44:21
  SPEAKER_01: Guess that's not it.
• 44:22
  SPEAKER_02: Oh, no, no.
• 44:23
  SPEAKER_03: I'm just trying to think of when I graduated and um I think.
• 44:27
  SPEAKER_02: And all those years like blur together.
• 44:30
  SPEAKER_02: They really do.
• 44:30
  SPEAKER_02: Was it Clinton?
• 44:31
  SPEAKER_02: Good guess.
• 44:32
  SPEAKER_02: Point to Jen for that one.
• 44:34
  SPEAKER_02: Excellent.
• 44:35
  SPEAKER_02: All right, so then this one, uh, Matt, not to stereotype, could be a question for you.
• 44:40
  SPEAKER_02: So who won the Super Bowl the first year it was effective?
• 44:43
  SPEAKER_02: So that would be 1993.
• 44:45
  SPEAKER_02: Although, if you know this, I'm gonna be very impressed.
• 44:50
  SPEAKER_01: Well, I'm a Dallas guy.
• 44:51
  SPEAKER_01: I'm just gonna guess and go with the Dallas Cowboys.
• 44:54
  SPEAKER_02: I am amazed, but yes, that is the correct answer.
• 44:58
  SPEAKER_01: Maybe their last one now that I now that I think about it.
• 45:01
  SPEAKER_02: Well, anyway, I don't know if the producer knew knows that you're a Dallas Cowboys fan, but very impressive because I think no way.
• 45:09
  SPEAKER_01: Around that time.
• 45:10
  SPEAKER_01: Somewhere around that time, yes.
• 45:12
  SPEAKER_02: Very good.
• 45:12
  SPEAKER_02: All right, well, see, what a great note to end on.
• 45:15
  SPEAKER_02: You guys got both of those questions right.
• 45:17
  SPEAKER_02: So, as always, thanks so much for joining me.
• 45:19
  SPEAKER_02: I appreciate all the insights.
• 45:21
  SPEAKER_01: Thank you.
• 45:22
  SPEAKER_02: Thank you.
• 45:23
  SPEAKER_02: That's our show for today.
• 45:25
  SPEAKER_02: Join me this Thursday for another episode in our climate disclosure series.
• 45:30
  SPEAKER_02: And next Tuesday, join me for the launch of a new Toolkit series.
• 45:36
  SPEAKER_02: June will be all about leases.
• 45:39
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• 45:41
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• 45:46
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• 45:56
  SPEAKER_02: From thought leadership at PwC, I'm Heather Horn.
• 46:00
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