Even as companies grapple with the effects of the COVID-19 pandemic, many calendar year businesses are preparing to issue their first quarter earnings, and some fiscal year filers are preparing to issue their annual reports. In terms of accounting for income taxes under Accounting Standards Codification (ASC) 740, there are a number of challenges ahead, particularly due to the expected volatility of earnings and forecasts for 2020. An additional layer of complexity may be added when taking into consideration the Financial Accounting Standards Board’s (FASB) recently issued Accounting Standards Update (ASU) 2019-12.
Valuation Allowance Considerations
Given the economic uncertainty surrounding the remainder of 2020, companies will undoubtedly see increased scrutiny from auditors, regulators and financial analysists regarding the realizability of deferred tax assets (DTAs) on the balance sheet. Businesses that are facing losses for the current year should consider the available sources of future taxable income to realize a benefit from their current losses or other deductible temporary differences. ASC 740 currently provides the following four sources of future taxable income1.
- Taxable income in prior carryback year(s) if carryback is permitted under the tax law (still applies in some states and foreign jurisdictions but is mostly inapplicable now for U.S. federal purposes).
- Future reversals of existing taxable temporary differences, which are also known as deferred tax liabilities (DTLs).
- Tax-planning strategies (difficult to rely on now in the U.S. federal jurisdiction due to the indefinite net operating loss carryover period).
- Future taxable income exclusive of reversing temporary differences and carryforwards (subjective evidence, especially in the face of cumulative losses in recent years).
As noted above, the first and third items are difficult to rely on as sources of income after the 2017 Tax Cuts and Jobs Act (TCJA). The fourth item becomes difficult to rely on if there have been cumulative losses or a lack of reliable financial forecasts. For many companies, that leaves the reversal of existing DTLs as the only reliable source of future taxable income. This places significant importance on a company’s ability to schedule out the reversal of their existing DTLs to demonstrate the realizability of their DTAs.
If a company determines that a change in its valuation allowance position is needed during an interim period, the company must further evaluate whether the change is caused by current-year ordinary income or loss items, or is caused by a change in judgment regarding the realizability of deferred tax assets based on income that is expected to be available in future years. To the extent that the change in valuation allowance relates to current year ordinary income or loss items, it should be reflected in the Estimated Annual Effective Tax Rate (EAETR) for the period. To the extent that the change relates to a change in judgement regarding future income or loss items, the effects should be reflected as discrete items for the period rather than being included in the EAETR2.
Non-Benefited Losses in Separate Jurisdictions
An additional interim period consideration for valuation allowances is the possible impact on the EAETR approach under ASC 740-270 (formerly known as FIN 18). If a company anticipates ordinary losses in a separate jurisdiction for which no tax benefit should be recognized due to the assessment of a valuation allowance, then the entity or entities in that jurisdiction must be excluded from the worldwide EAETR and should instead be assessed with a separate EAETR (most likely a zero rate, absent refundable tax credits or other unique items)3.
Ability to Estimate the Annual Effective Tax Rate
For interim reporting, many companies use the simplified EAETR approach provided by ASC 740-270. However, this methodology is dependent on an entity’s ability to reliably estimate its future ordinary income or loss and the related tax expense or benefit. In situations where a company is not able to reliably estimate these, it may not be appropriate to use the simplified interim approach, and a calculation of the actual effective year to date tax rate may be required4. Companies should be prepared for the possibility of increased scrutiny regarding their ability to forecast future results of operations given the uncertainties surrounding COVID-19.
Limitation on Losses in Interim Periods
Notwithstanding the previous discussion of valuation allowances, an entity calculates its EAETR and applies that rate to year-to-date income or loss under the interim period guidance of ASC 740-270. However, current guidance includes an exception for situations where the year-to-date loss in an interim period exceeds the expected loss for the full tax year.
ASU 2019-12 removes this benefit limitation exception. For companies facing significant losses in the first quarter but expecting income in future quarters within the current reporting year, early adoption of ASU 2019-12 may have a material impact on the after-tax loss incurred during the first quarter.
1 ASC 740-10-30-18.
2 ASC 740-270-25-4.
3 ASC 740-270-30-32.
4 ASC 740-270-30-18.
Intraperiod Tax Allocation to Losses from Continuing Operations
ASC 740 provides a general framework for allocating tax expense between financial statement components (such as continuing operations, discontinued operations and other comprehensive income). The framework begins by allocating tax expense or benefit to continuing operations and then allocates the residual of total tax expense or benefit to other components. In general, the tax effect of income from continuing operations should be determined without considering the tax effect of other financial statement components. Current guidance provides an exception to the general framework in situations where there is a loss from continuing operations and a gain within another financial statement component. This exception often resulted in allocating a tax benefit to continuing operations and tax expense to another component, even when total tax expense may have been zero.
ASU 2019-12 removes this exception to the general framework. In many instances, removing the exception will now result in allocating zero tax expense or benefit to continuing operations where prior guidance would have allocated a tax benefit to continuing operations. For companies in this situation, the timing of adoption of ASU 2019-12 could impact the after-tax loss from continuing operations.
Other Matters and Summary
For some companies, there are other items within ASU 2019-12 that could materially impact after tax earnings. For example, companies with a pending change in ownership of a foreign entity (change from a foreign equity method investee to a consolidated subsidiary, or vice versa) should pay close attention to the changes provided in the new guidance.
Companies should carefully consider how the guidance of ASU 2019-12 impacts their specific fact pattern. As all guidance with the ASU must be simultaneously adopted, companies should evaluate all possible impacts when determining when to adopt. For public companies, ASU 2019-12 is effective for fiscal years (and interim periods within those fiscal years) beginning after Dec. 15, 2020. For non-public companies, the standard is effective for fiscal years beginning after Dec. 15, 2021, and interim periods within fiscal years beginning after Dec. 15, 2022. Early adoption is permitted but requires simultaneous adoption of all provisions of the new standard.
For more information regarding accounting for income taxes, first quarter 2020 reporting considerations or questions regarding ASU 2019-12, please contact us at firstname.lastname@example.org.