18.2 Valuation Allowances and NOLs

Valuation Allowances and NOLs

A critical component of accounting for income taxes is evaluating the realizability of deferred tax assets. Because deferred tax assets represent future tax savings, they are only valuable if the company generates sufficient taxable income in the future to absorb the deductions or carryforwards. Under ASC 740, companies must assess whether a valuation allowance is necessary to reduce the carrying amount of their deferred tax assets to the amount that is more likely than not to be realized.

The Valuation Allowance and the More-Likely-Than-Not Threshold

A valuation allowance is a contra-asset account that reduces a deferred tax asset. A company must establish or adjust a valuation allowance if, based on the weight of available evidence, it is more likely than not (a likelihood of more than 50%) that some portion or all of the deferred tax assets will not be realized.

• More Likely Than Not (MLTN) Criteria: The assessment requires weighing all available evidence, both positive and negative, to determine whether sufficient taxable income will exist in future years. The evidence must be objective and verifiable.

Sources of Taxable Income to Realize DTAs:

1. Future reversals of existing taxable temporary differences (DTLs).
2. Future taxable income exclusive of reversing temporary differences and carryforwards.
3. Taxable income in prior carryback years (if carrybacks are permitted by law).
4. Tax planning strategies that are prudent and feasible, which the company would implement to prevent an operating loss or tax credit carryforward from expiring.

Negative Evidence (suggesting an allowance is needed):

• Cumulative losses in recent years (usually a three-year historical period is heavily weighted).
• A history of operating losses or tax credit carryforwards expiring unused.
• Losses expected in early future years by a company in a cyclical industry.
• Unsettled circumstances or contingencies that, if resolved adversely, would negatively affect future operations.

Positive Evidence (suggesting no allowance is needed):

• Existing contracts or a strong backlog that will generate significant future profits.
• An excess of appreciated asset value over the tax basis of the entity’s net assets in an amount sufficient to realize the deferred tax asset.
• A strong history of profitability and earnings power.

Journal Entries for Valuation Allowance

If a company determines that it needs to establish or increase a valuation allowance, it records a charge to income tax expense.

For example, if Beta Corp has a DTA of $100,000 but determines that it is more likely than not that $30,000 of this DTA will not be realized, it records the following entry:

Debit: Income Tax Expense (Deferred)     $30,000
  Credit: Valuation Allowance - DTA               $30,000

If in a subsequent year, circumstances improve (e.g., the company returns to sustained profitability) and the company determines that the allowance is no longer needed, it reverses the allowance:

Debit: Valuation Allowance - DTA         $30,000
  Credit: Income Tax Expense (Deferred)           $30,000

This reversal represents a tax benefit that increases net income in the period of change.

Net Operating Losses (NOLs)

A Net Operating Loss (NOL) occurs when a company's tax-deductible expenses exceed its taxable revenues on the tax return. An NOL is a tax benefit because it can be used to offset taxable income in other years, thereby reducing taxes payable.

Tax Law Framework (Post-TCJA Rules)

Under current U.S. federal tax law (following the Tax Cuts and Jobs Act of 2017):

• Carryback: Federal NOLs arising in tax years beginning after December 31, 2017, cannot be carried back to offset prior years' taxable income (except for certain specialized industries like farming).
• Carryforward: These NOLs can be carried forward indefinitely (they do not expire).
• 80% Limitation: The deduction for NOL carryforwards in any tax year is limited to 80% of taxable income (calculated before the NOL deduction is applied).

Accounting for NOLs under GAAP

Because an NOL carryforward represents a future deduction that will reduce future taxable income, it creates a Deferred Tax Asset (DTA).

• Calculation: The DTA is calculated by multiplying the NOL carryforward amount by the enacted tax rate expected to apply when the NOL is utilized.
• Valuation Allowance considerations: Since an NOL occurs when a company is in a loss position, the presence of an NOL is strong negative evidence. Consequently, companies with significant NOLs often must establish a valuation allowance against the resulting DTA, unless they have sufficient DTLs reversing in future years or strong positive evidence of future profitability.

For example, if Gamma Corp incurs an NOL of $500,000 in Year 1 when the enacted tax rate is 21%, it records a DTA of $105,000 ($500,000 * 21%):

Debit: Deferred Tax Asset                $105,000
  Credit: Income Tax Expense (Deferred)           $105,000

If Gamma determines that it is more likely than not that only 40% of the DTA will be realized, it must establish a valuation allowance of $63,000 ($105,000 * 60%):

Debit: Income Tax Expense (Deferred)     $63,000
  Credit: Valuation Allowance - DTA               $63,000

ASU 2023-09 Disclosures

In December 2023, the FASB issued ASU 2023-09, Income Taxes (Topic 740): Improvements to Income Tax Disclosures. This standard enhances the transparency of income tax disclosures, focusing on the rate reconciliation table and disclosures of income taxes paid.

1. Tabular Rate Reconciliation (for Public Entities)

Public entities must disclose a tabular reconciliation of the federal statutory income tax rate to the effective tax rate. ASU 2023-09 requires specific categories to be presented, and any individual reconciling item within these categories that is equal to or greater than 5% of the statutory tax rate must be disaggregated and disclosed separately. The categories include:

• State and local income taxes, net of federal income tax effect.
• Foreign tax effects (tax rate differences in foreign jurisdictions).
• Effects of changes in tax laws or rates enacted in the period.
• Effect of changes in valuation allowances.
• Tax credits.
• Nondeductible expenses or tax-exempt income.

Nonpublic Entities: Nonpublic entities are exempt from the tabular reconciliation but must provide a qualitative (narrative) disclosure of the nature of the reconciling items and the statutory tax rate.

2. Income Taxes Paid Disclosures

Both public and nonpublic entities must disclose the amount of income taxes paid (net of refunds received), disaggregated by:

• Federal government.
• Individual states.
• Foreign countries.

Crucially, companies must separately disclose the amount of taxes paid to any individual state or foreign country if that amount is equal to or greater than 5% of the total income taxes paid (net of refunds). This prevents companies from burying significant tax payments to specific jurisdictions in a global "other" category.