Chapter Summary
ASC 740-10-45-20 provides the primary guidance for recording the effects of a change in valuation allowance that occurs during the year. This guidance requires that a change in valuation allowance be sourced to financial statement categories based on several factors, including whether a deferred tax asset was benefited in the year during which it was established and whether the taxable income used to support realization of the deferred tax asset results from the current year or future years. Because the language used in ASC 740-10-45-20 and ASC 740-20-45-1 through 45-14 can sometimes lead to counterintuitive results, this guidance should only be viewed in conjunction with ASC 740’s model for intraperiod allocation, which is discussed more fully in Chapter TX 12.
6.1 Recording the Effects of Changes in Valuation—In General
ASC 740-10-45-20 provides general guidance for recording the effects of changes in valuation allowance recorded during the year. ASC 740-10-45-20 essentially groups valuation allowances into the following four categories:
Effects of a change in the beginning-of-the-year balance of a valuation allowance that results from a change in circumstances that causes a change in judgment about the realizability of the related deferred tax asset in future years should be recorded to continuing operations (see Section TX 12.2.2.2.3).
Effects of a change to valuation allowances of certain tax benefits that are adjusted within the measurement period as required by paragraph 805-740-45-2 related to business combinations (see Section TX 10.5.5).
Effects resulting from the initial recognition (that is, by elimination of the valuation allowance) of tax benefits related to the items specified in ASC 740-20-45-11(c)–(f). These items are allocated to the related component of shareholder’s equity that gave rise to the underlying benefit that is being initially recognized. We refer to these items as “source of loss” items (see Section TX 12.2.2.2.3.2 for a more detailed discussion of “source of loss” items).
All other changes should be allocated based on ASC 740’s general rules for intraperiod allocation (see Section TX 12.2 for the general rules surrounding ASC 740’s incremental approach to allocating tax expense or benefit for the year).
6.2 Changes in Valuation Allowance in Specific Areas
6.2.1 Changes in Valuation Allowance—Business Combinations
6.2.1.1 Establishment of a Valuation Allowance Against an Acquired Company’s Deferred Tax Assets at the Time of Acquisition
ASC 805-740-25-3 requires an acquirer to assess the need for a valuation allowance as of the acquisition date for an acquired entity’s deferred tax asset in accordance with ASC 740-10. If a valuation allowance is required to be recorded against deferred tax assets acquired in a business combination, it would be recorded as part of acquisition accounting. See Section TX 10.5.2.
6.2.1.2 Changes to the Acquired Deferred Tax Assets in a Period Subsequent to a Business Combination
Under ASC 805-740-45-2, a change in valuation allowance that does not qualify as a measurement period adjustment is reflected in income tax expense (or as a direct adjustment to contributed capital as required by ASC 740-10-45-20 through 45-21). A change in valuation allowance within the measurement period resulting from new information about facts and circumstances that existed at the acquisition date is reflected as an adjustment to goodwill. However, once goodwill is reduced to zero, an acquirer shall recognize any additional decrease in the valuation allowance as a bargain purchase.
The acquirer must consider whether changes in the acquired deferred tax balances are due to new information about facts and circumstances that existed at the acquisition date or are due to events arising in the post-combination period. Discrete events or circumstances that arise within the measurement period and did not exist at the acquisition date generally would not be recorded in acquisition accounting. See Section TX 10.5.5.
Unlike the general transition provisions of ASC 805, whereby the guidance is applied only to business combinations consummated after the effective date of ASC 805, the guidance related to the release of a valuation allowance subsequent to the date of an acquisition also applies to business combinations consummated prior to the effective date of ASC 805.
6.2.1.3 Changes in the Acquirer’s Valuation Allowance at the Time of a Business Combination
Pursuant to ASC 805, the impact on the acquiring company’s deferred tax assets and liabilities caused by an acquisition is recorded in the acquiring company’s financial statements outside of acquisition accounting (i.e., not as a component of acquisition accounting). This applies to a change in tax rate expected to be applicable when the deferred tax assets and liabilities reverse as well as a release or recognition of all or part of a valuation allowance against the acquirer’s deferred tax assets as a result of the business combination. Such impact is not a part of the fair value of the assets acquired and liabilities assumed; therefore, the decrease in valuation allowance must be recorded in the income tax provision (subject to intraperiod allocation) of the acquirer. Similarly, if a valuation allowance is required on the acquirer’s deferred tax assets as a result of the acquisition, the impact should be reflected in the acquirer’s income tax provision at the date of the acquisition and not as a component of acquisition accounting. See Section TX 10.5.6.
6.2.1.4 Effects of Tax Law Changes on a Valuation Allowance Recorded Against Acquired Tax Benefits in a Business Combination
The tax effects of a change in tax law or regulation that result in a change in valuation allowance that was initially recorded in acquisition accounting is recorded in continuing operations in the period of enactment. See Section TX 7.5.1 for further guidance.
6.2.1.5 Ordering of Recognition of Tax Benefits
Since the treatment of the initial recognition of tax benefits from “source of loss” items are treated differently from other tax benefits that are recognized within a year, when benefits from both “source of loss” and non- “source of loss” are recognized during the year, there is a need to determine which tax benefit was recognized. See Section TX 12.2.2.2.3.3 for a discussion of the ordering rules that should be followed in making this determination.
6.2.2 Changes in Valuation Allowance Related to Items of Other Comprehensive Income
See Section TX 12.2.3.2.2.2 for a discussion of common intraperiod allocation issues, including changes in valuation allowances relating to unrealized appreciation and depreciation on available-for-sale (AFS) securities accounted for under ASC 320, Investments, and other items of other comprehensive income.
6.2.3 Changes in Valuation Allowance Resulting from Transactions Among or with Shareholders
ASC 740-10-45-21 states that “changes in valuation allowances due to changed expectations about the realization of deferred tax assets caused by transactions among or with shareholders should be included in the income statement.” In addition, the guidance indicates that a write-off of a pre-existing deferred tax asset that an entity can no longer realize as a result of a transaction among or with its shareholders should similarly be charged to the income statement, since the same net effect results from eliminating a deferred tax asset and increasing a valuation allowance to 100 percent of the amount of the related deferred tax asset.
See Section TX 10.8 for a discussion of the effects of release of a valuation allowance as a result of a transaction with a noncontrolling shareholder.
6.2.3.1 NOL Carryforward Limitation Following an Initial Public Offering
Assume that an entity, after completing an initial public offering, is required to reduce its deferred tax assets or increase its valuation allowance related to NOL carryforward amounts for which future utilization is limited as a result of the tax change in ownership rules. Should the tax consequences of this change be charged to contributed capital or recognized in the income statement?
The effects of writing off a deferred tax asset (or recording a valuation allowance) in these circumstances should be recognized in the income statement. ASC 740-10-45-21 concluded that changes in valuation allowances due to changed expectations about the realization of deferred tax assets caused by transactions among or with shareholders should be included in the income statement. The guidance further concluded that the write-off of a preexisting deferred tax asset in these circumstances should be charged to income, because the same net effect results from eliminating a deferred tax asset or increasing a valuation allowance to 100 percent of the amount of the related deferred tax asset. This guidance may differ from the guidance for changes in tax bases of assets and liabilities that are caused by transactions with or among shareholders for which ASC 740-20-45-11(g) concluded the related tax effects should be included in equity. See Section TX 12.2.3.3.2 for further discussion.
6.2.4 Transactions between Entities under Common Control
See Section TX 10.9.1 for a complete discussion of the accounting for a change in the valuation allowance as a result of a common control transaction.
6.2.5 Changes in Valuation Allowance in Spin-Off Transactions
6.2.5.1 Recording an Increase to a Parent’s Valuation Allowance When a Subsidiary Is Spun Off in a Nontaxable Transaction
In the United States, if a parent spins off more than 20 percent of a subsidiary in a nontaxable transaction that is recorded as a distribution to shareholders, the subsidiary would be excluded from the consolidated tax return. As a result, the parent may conclude that a valuation allowance against its deferred tax asset is necessary now that the subsidiary’s taxable temporary differences are no longer available as a source of future taxable income to the parent. In this case, the charge for the establishment of the valuation allowance should be to continuing operations. Although the realizability assessment of the parents deferred tax assets may have changed due to the decision to spin off the subsidiary, it is accounted for separate and apart from the spin transaction.
6.2.5.2 Recording a Valuation Allowance on a Subsidiary’s Assets When a Spin-Off Creates the Need for a Valuation Allowance
In certain cases, deferred tax assets exist related to the subsidiary that are supportable in consolidation, but will, upon spin-off, require a valuation allowance. An issue arises as to whether this impairment should be recognized in the consolidated financial statements prior to the spin-off. In such cases, we understand that the FASB staff has concluded that the consolidated financial statements of the parent should reflect a charge to continuing operations at the time of the spin-off, even though such a charge would not have been required if the spin-off had not occurred. The staff’s view appears to be based on a conceptual argument that the parent is not transferring the deferred tax assets at the value at which those assets were recorded in consolidation. Rather, the deferred tax assets have been impaired by the decision to spin off the business into a separate entity that, more-likely-than-not, will be unable to realize the value of those deferred tax assets. This charge should also be reflected in the standalone financial statements of the subsidiary (or will have already been reflected in earlier periods, if the subsidiary was accounting for deferred taxes in accordance with the separate return method described in Section TX 14.1.1).
6.2.6 Changes in Valuation Allowance When Restating Prior-Period Presentation for Discontinued Operations
See Section TX 12.2.3.2.4.1 for a discussion on restating prior-period presentation for discontinued operations when there is a change in the beginning-of-the-year valuation allowance that results from a change in assessment about future realizability of deferred tax assets.