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Fluid Income Projections Complicate Quarterly Tax Provisions

Posted on Apr. 14, 2020

Companies preparing quarterly financial reports are facing daunting challenges in determining the tax implications of the economic downturn and coronavirus relief legislation in part because they must predict the unpredictable.

Practitioners speaking on their firms’ recent webcasts alerted companies to the accounting and financial reporting complexities stemming from economic uncertainty and implementation of the Coronavirus Aid, Relief, and Economic Security (CARES) Act (P.L. 116-136).

Reduced revenue, supply chain disruption, and increased exposure to customer credit risk are among the issues that will have significant financial reporting implications for companies, Daryl Buck of Grant Thornton LLP said.

According to Paul Beswick of EY, this is a “period of unprecedented change” that requires management to make difficult judgments in several accounting areas, including asset recoverability, debt covenants, and income taxes.

“One of the things that I think companies are grappling with the most right now is, what does the next three, six, nine months look like?” Beswick said. Determining prospective financial information will be particularly challenging because that involves making assumptions about when the economic crisis will end and doing scenario planning, he said.

Beswick welcomed SEC Chief Accountant Sagar Teotia’s April 3 statement noting that SEC staff will accept well-reasoned judgments that entities have made in assessing the accounting and financial reporting implications of the coronavirus pandemic.

Graham Dyer of Grant Thornton also commented on the challenging task of forecasting economic conditions and expected cash flows in times of economic uncertainty. He advised companies to identify relevant and reliable information and document how management made judgments and why they are appropriate under the circumstances.

“All of this has to be buttressed by informative and transparent disclosures,” Dyer said.

In accounting for income taxes, practitioners identified increased complexity in several areas: estimating annual effective tax rates; determining the realizability of deferred tax assets, along with corresponding valuation allowances; and assessing indefinite reinvestment assertions.

Effective Tax Rates

The Financial Accounting Standards Board’s guidance on accounting for income taxes requires companies to estimate their annual effective tax rate, but “the fluidity of the projections of book income makes that somewhat challenging,” said Angela Evans of EY.

Steve Barta of Deloitte & Touche LLP agreed, saying that some companies might struggle with earnings projections and that their tax rate “may be highly sensitive to changes in estimated income.” In those situations, Barta said, the company’s actual year-to-date effective tax rate might be the best estimate of the annual rate, which is an allowable exception under FASB’s rules.

If that’s the case, management should consider disclosing that it couldn’t make a reliable estimate of the overall tax rate for the year, April Little of Grant Thornton advised.

Also, the “key inputs and assumptions used in forming tax accounting estimates” should be consistent with those used in other financial accounting estimates, Little emphasized.

Changes in Law

Companies preparing financial statements for the quarter that ended March 31 also must account for the income tax effects of the CARES Act, which was enacted March 27.

Little pointed out that many other countries have enacted tax laws that provide stimulus and relief for affected entities, which might also need to be considered in quarterly financial reports. However, determining the enactment date in those countries requires an understanding of each jurisdiction’s legislative process, because the date may not be when the president signs the legislation, she said.

And if the foreign jurisdictions have “tax favors, tax holidays, [or] deferrals of taxes,” companies must assess their eligibility and determine the income tax accounting and financial reporting implications, Little added.

For retroactive provisions, like some in the CARES Act, the effects on prior years’ income taxes payable or receivable are recognized in tax expense from continuing operations as of the date of enactment, Little said. If the changes affect taxes payable or receivable in the current year, those effects are generally “considered in determining the overall estimated annual effective tax rate beginning in the period of enactment,” she explained.

Entities must also remeasure their deferred tax assets and liabilities and determine valuation allowance changes, which are reported as discrete items in the current period. If a company determines that it is more likely than not that the value of a deferred tax asset — such as net operating loss and business interest expense carryovers — won’t be fully realized, a valuation allowance must be determined and disclosed.

Little pointed out that if entities haven’t finalized their tax accounting for the 2019 calendar year, the CARES Act is considered “a subsequent event that would not be considered in the [year-end] income tax provision, even in the valuation allowance assessment.”

However, Little said those companies should consider discussing the effects of the CARES Act and of the pandemic in subsequent disclosures.

‘Computational Gymnastics’

Companies’ decisions on how to mitigate the economic effects of the coronavirus pandemic — such as whether to carry back NOLs — could affect changes in the valuation allowance for the quarter.

Congress modified section 172 to address liquidity issues arising from the pandemic by temporarily repealing the 80 percent NOL limitation and allowing deductions for loss carryovers and carrybacks to fully offset taxable income for tax years beginning before January 1, 2021.

The new law also allows companies to carry back losses arising in tax years from 2018 through 2020 for up to five years before the year of the loss.

Companies should consider the incremental benefit that can be “derived from carrying back tax attributes to years that have a 35 percent income tax rate . . . compared to using those same attributes in a tax year that has a 21 percent tax rate,” Little said.

If companies can monetize NOLs under the CARES Act’s five-year carryback rule, they may be able to reduce or eliminate the need for a valuation allowance, Little added. “At the same time, entities are still evaluating the negative economic impacts of COVID-19, resulting in potential impairments in goodwill, intangibles, and other assets,” which could decrease deferred tax liabilities and therefore affect the valuation allowance assessment, she said.

And reductions in projected earnings could reduce the positive evidence in assessing the realizability of the deferred tax assets, Little explained.

“With all the interrelated computational gymnastics” stemming from the pandemic’s economic effects and the CARES Act, complex modeling and scheduling might be required to determine the opening valuation allowances related to the economic environment and to the new law, according to Little.

Evans advised audit committee members preparing for quarterly financial reports to focus on the company’s “tax posture” concerning NOLs from 2018 through 2020 that can be carried back. That’s because of the resulting complexities in the income tax provision and the ancillary effects of carrying back losses, she explained.

“Not only will those losses be available to carry back to as early as 2013 to recover the 35 percent taxes paid in those earlier years, but doing so will impact foreign tax credit carryovers, and potentially the transition taxes that were paid in 2017 and 2018 for multinational companies,” Evans said.

Carrying back losses could also affect 2018 and 2019 calculations for global intangible low-taxed income, the base erosion and antiabuse tax, and foreign-derived intangible income, Evans warned. Intricate modeling might be needed to understand those effects and true up all the tax attributes, she added.

“We’re expecting companies to make their best estimates for this quarter and continue to refine the precision of those numbers over the next few quarters, because this is very fluid,” Evans said.

Accessing Offshore Cash

Practitioners also warned that companies could need to revisit indefinite reinvestment assertions if they plan to tap into a foreign subsidiary’s cash.

Companies evaluating the pandemic’s negative effects and the cash flow relief provided by the CARES Act may contemplate alternative sources of funds, which could include cash from the earnings of foreign subsidiaries that were previously considered indefinitely reinvested, Little said.

“In this uncertain environment, it is important to evaluate . . . whether there have been changes in working capital needs or operating plans that would impact the company’s ability to continue to assert indefinite reinvestment,” Little advised. “Changing this assertion may give rise to additional deferred tax liabilities, which may in turn impact the valuation allowance assessment.”

Evans said that if companies are considering accessing cash offshore, “the accounting for any resulting taxes of dipping into that cash needs to be reflected in the quarter of the decision to bring the money back, regardless of whether the cash is actually bought back in the quarter.”

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