Gains & Losses
Accounting Standards Codification (ASC) ¶ 740-20-45-11 states that when an entity has a history of net operating losses (NOLs) and is reasonably expected to generate NOLs for the current period, the deferred tax assets are treated as having no current value or, as commonly referred to in tax accounting, “a full valuation.”
Example 1: Company A has a history of generating NOLs on a GAAP basis. In the current year, A generates a research and development tax credit for U.S. federal tax purposes. Because there is no historical evidence that A will generate taxable income to use the tax credit, a full valuation is recorded for balance sheet presentation purposes, and no tax benefit is recorded in calculation of the effective tax rate.
In determining the appropriate tax accounting treatment for entities withhistorical NOLs, this is common practice and is in accordance with ASC ¶740-20-45-11 rules and guidelines.
An anomaly occurs when the following specific fact pattern develops:
- The entity generates a GAAP NOL in the current period; and
- The entity generates net unrealized gains in the current period.
In accordance with ASC ¶740-20-45-7, the entity records a tax benefit in calculation of the tax provision for income statement purposes and a deferred tax liability in other comprehensive income.
Example 2: Company B generates a GAAP NOL of $20 million in 2010 and a net unrealized gain of $2 million from securities available for sale in the same year. At year-end 2010, B accounts for the NOL and unrealized gain as follows: (1) an NOL is recorded with no estimated future benefit or full valuation and net zero presentation on the balance sheet, and (2) unrealized gain is recorded with $700,000 tax benefit ($2 million × 35% tax rate) for tax provision purposes on an income statement and $700,000 tax-deferred liability in other comprehensive income.
Although counterintuitive to the general rule, the conceptual basis for the tax accounting treatment of this specific fact pattern is recognition on a pro forma basis of the unrealized gain reduced by utilization of NOLs. This results in a benefit in the current period for tax provision purposes without regard to the pro forma or other comprehensive income nature of the event. This is supported by the Financial Accounting Standards Board (FASB) in ASC ¶740-20-45-7, which states:
The tax effect of pretax income or loss from continuing operations generally should be determined by a computation that does not consider the tax effects of items that are not included in continuing operations. The exception to that incremental approach is that all items (for example, extraordinary items, discontinued operations, and so forth) be considered in determining the amount of tax benefit that results from a loss from continuing operations and that shall be allocated to continuing operations. That modification of the incremental approach is to be consistent with the approach in Subtopic 740-10 to consider the tax consequences of taxable income expected in future years in assessing the realizability of deferred tax assets. Application of this modification makes it appropriate to consider an extraordinary gain in the current year for purposes of allocating a tax benefit to a current-year loss from continuing operations.
This position is further supported by FASB in Topic No. D-32, on intra-period tax allocation of the tax effect of pretax income from continuing operations, which states that FASB staff believes that FAS No. 109 (now ASC Topic 740) “generally requires that the tax effect of pretax income from continuing operations be determined by a computation that does not consider the tax effects of items that are not included in continuing operations.”
On a prospective basis, if the entity continues to generate NOLs and net unrealized gains in the current period, additional tax benefits and deferred tax liabilities are recorded, respectively. Alternatively, if the entity generates net unrealized losses, there is no entry to record.
If the entity sells the investment, the deferred tax liability is removed and a tax expense is recorded for tax provision purposes in the current period. Assuming the entity buys and sells investments periodically, this will require constant tracking of individual investments and volatility in the entity’s effective tax rate. An alternative to tracking individual investments for purposes of ASC ¶740-20-45-7 is to adopt the accounting method of tracking investments as a group. This is known as the portfolio approach.
Under this approach, sales of investments are viewed as replaced by the purchase of additional investments. In concept, investments previously recorded with unrealized gains are not permanently sold; rather, they are replaced on a perpetual basis. The approach effectively defers removal of deferred tax liability in other comprehensive income and tax provision benefit recorded in the income statement until the entire investment portfolio is liquidated. Assuming the entity is a going concern, the prior-period entities are carried forward indefinitely.
In conclusion, tax accounting practitioners should review entities generating NOLs with an investment portfolio to determine the application of ASC ¶740-20-45-7. If the applicable fact pattern exists, the appropriate tax accounting posting should be recorded and consideration given to investment tracking on an individual or group basis.
EditorNotes
Michael Koppel is with Gray, Gray & Gray, LLP, in Westwood, MA.
Unless otherwise noted, contributors are members of or associated with CPAmerica International.
