Cross-post: More on SEC comment letters and Tesla's tax accounting
SEC comments on tax valuation allowance are uncommon and may lead to changes in accounting.
This is a cross-post with Deep Quarry, the newsletter I occasionally collaborate on with Olga Usvyatsky. If you value our work, please subscribe!
In my previous post I discussed why I believe Tesla’s release of a $5.9 billion tax valuation allowance was likely prompted by the SEC’s Division of Corporation Finance (Corp Fin) comment letters. In this piece, I would like to use Tesla’s comment letters to illustrate several methodological techniques I use to flag SEC comments that warrant more attention.
To recap, the primary points in my previous piece were:
Tesla’s release of the tax valuation allowance was likely prompted by the Corp Fin’s regulatory review and was not the result of a voluntary internal reassessment by Tesla executives and its auditor PwC of future profitability and the proper application of GAAP.
The SEC is likely closely monitoring Tesla’s disclosures. The issuance of a “no further comments” letter just one day after the earnings release that revealed an accounting change that led to the release of the valuation allowance is, in my opinion, not coincidental.
Tesla did not admit in its written responses to the SEC that the release of the tax valuation allowance was appropriate, raising questions about whether SEC’s comments were discussed and/or resolved during a phone call rather than documented clearly in now-public correspondence.
Let’s look at several additional insights from the SEC's comments to Tesla.
Disclosure versus accounting
In contrast to the SEC’s Division of Enforcement (DOE), which investigates misconduct, Corp Fin’s comment letter process aims to improve transparency by enhancing disclosure. Consequently, most SEC comments seek to improve clarity around insufficient or inconsistent disclosure. Most Corp Fin comments — and there are always exceptions — are relatively minor and are resolved by providing additional disclosure in future filings.
However, sometimes the SEC Corp Fin raises questions about whether a specific accounting treatment is appropriate. Accounting-related comments often require the issuer to provide detailed accounting or legal support to justify its accounting for a specific transaction or its reliance on a specific accounting method. Arguably, these comments are more material because they can lead to changes in numbers in the financial statements.
Material changes — such as Tesla’s $5.9 billion release of its tax valuation allowance — are puzzling and raise the question: Why now? What changed since the last periodic report?
The narrative of SEC comments provide more context, and in this case explains why SEC Corp Fin believed that maintaining a full tax valuation allowance is no longer appropriate.
Positive versus negative impact
Accountants are generally concerned about accounting numbers painting an overly optimistic picture of a company’s fundamentals — namely, overstatements of revenue, net income, or assets or understatements of expenses or liabilities. Concerns about understatements of net income pop up, for example, when there is a risk of “cookie jar” accounting.
SEC’s comments to Tesla do not mention the “cookie jar” issue and do not raise concerns about any shifting of earnings from one period to another. Yet, the SEC inquires whether Tesla’s tax valuation allowance should have been released sooner — that is, whether net deferred tax assets and net income were understated in the past.
Maintaining a full valuation allowance implies that a company does not expect to realize the tax benefits inherent in the net deferred tax assets balance because it will not have sufficient U.S. taxable income. However, estimates of future profitability involve discretion and require substantial judgment calls.
In its December 15, 2023, response to the SEC, Tesla noted several macroeconomic and company-specific challenges that impeded its ability to project future taxable income beyond 2023. The excerpts from SEC’s comments and Tesla’s responses are below.
SEC Comment:
“Tell us what consideration you gave to future taxable income in years beyond 2023. If no other future periods were considered, explain why you believe that a one year forecast is adequate in your assessment of deferred tax asset realization. It is unclear how you considered ASC 740-10-30-21b, which contemplates a multiple year forecast.”
Tesla’s response:
“Tesla’s unique business model also makes it difficult to reliably project future taxable income. As explained in detail below a significant part of Tesla’s long-term strategy is to achieve competitive advantage by increasing EV production and thus reducing per-unit costs. That strategy requires both the increased utilization of its four existing factories as well as the construction of new factories using newer manufacturing techniques, each of which is difficult to project with great certainty.
In addition, Tesla’s strategy is unique since unlike other automakers, Tesla relies heavily upon the continued development and commercial introduction of technologies such as autonomous driving, the DOJO supercomputer, and other technologies. Tesla faces significant challenges obtaining regulatory and other approvals to get these technologies to market and hence it creates additional complexity which is unique to Tesla. All of these factors make it difficult to rely upon projected future financial to overcome the negative evidence of cumulative losses for ASC 740 purposes.”
I will leave it to others to debate whether Tesla’s business model is “unique”. However, factors listed above - along with additional factors listed in Tesla’s responses to the SEC - can, in my opinion, introduce volatility to Tesla’s bottom line. Let me emphasize the uncertainty element in Tesla’s response. Tesla is not saying that the company will be unprofitable but is arguing that insufficient information exists to project profitability beyond 2023.
In my opinion, it’s a stretch to argue that Tesla strategically decided not to release the valuation reserve to create a cookie jar. The reasons could be purely practical. An accounting professor and a former Big 4 partner, Jeffrey Johanns, noted in a tweet that companies are penalized for releasing the valuation allowance too soon:
Tesla’s decision to maintain the full valuation allowance may have been driven by the fear that — should profits not materialize — the Company may need to reestablish the reserve and take income hits in the future. It is also possible that Tesla wanted to have a few more quarters of profitability before making the accounting change. However, the SEC comments pointing to a potential net income understatement are counterintuitive to its usual focus and, therefore, are interesting.
Each company is different, but historical data-driven context helps
To provide additional context for why Tesla’s comment letters are interesting, I searched the Audit Analytics comment letters database to identify SEC comments that mentioned tax valuation allowance.[1]
The analysis was limited to companies with a market cap of at least $100 million and to comment letters released in the past three years. The results are in Table 1 below.
My search identified 38 reviews that mentioned issues related to accounting or disclosure of tax valuation allowance - or 1.9% of 2,020 SEC 10-K reviews for that period.
In almost half of these reviews (17 out of 38), the question was raised in the context of non-GAAP presentations, and in more than 20% of the reviews (8 out of 38), SEC concerns were related to inconsistent disclosure of the tax valuation allowance across tables or footnotes.
I identified three cases in which the SEC had concerns about maintaining a full valuation allowance and all are in the last year: ServiceNow, Inc. (Ticker: NOW), Equitable Holdings, Inc. (Ticker: EQH), and Tesla (Ticker: TSLA). The conversation with the SEC started in April 2023, June 2023, and September 2023, for ServiceNow, Equitable Holdings, and Tesla, respectively.
The characteristics of SEC comments to ServiceNow in May 2023 are similar to Tesla’s in several ways (the entire response is available here):
ServiceNow maintained a full valuation allowance of about $1.2 billion against its deferred tax assets.
As of December 31, 2022, ServiceNow had been in a three-year cumulative loss position, and fiscal 2022 was the first year ServiceNow generated taxable income.
ServiceNow gave more weight to the three-year cumulative loss position (“the objectively verifiable evidence”) than to a positive management forecast in determining whether deferred tax assets will be realized.
ServiceNow responded to SEC comments on May 2, 2023, and announced the release of a $910 million tax valuation allowance in the earnings release dated July 26, 2023. (Note that the SEC issued a closing letter on September 14, 2023, more than four months after ServiceNow’s response. The average time to issue a closing letter was less than 20 days in 2023.)
Despite the similarities, there are also several differences. In contrast to Tesla, ServiceNow pointed the SEC to its disclosure in the quarterly report for the period ending March 31, 2023, indicating that it may release the valuation allowance in fiscal 2023:
“…given our current U.S. earnings and anticipated future earnings, we believe there is a reasonable possibility that prior to the fourth quarter of 2023 sufficient positive evidence of sustained U.S. profitability may become available to allow us to reach a conclusion that the U.S. valuation allowance will no longer be needed.”
SEC’s comments to Tesla appeared to be more nuanced and required more specific quantitative and qualitative evidence from Tesla to support its position. Note that while ServiceNow resolved SEC comments in one round, Tesla had two back-and-forth written exchanges with the SEC.
Extension of time requests
Companies are expected to respond to the SEC’s comments within ten business days. However, it is not uncommon for companies to request additional time to address the SEC’s questions. These extension requests are often caused by mundane reasons, such as a heavier-than-usual workload related to annual reports or upcoming holidays. In some cases, however, a company may need more time because the comments are more complex or because drafting a detailed, GAAP-based response requires a cross-team effort.
Notably, Tesla requested additional time twice (on October 2, 2023 and on November 28, 2023) during the conversation with the SEC, providing additional – albeit indirect – evidence that these comments were not easy to resolve.
For discussion of additional red flags, please contact olga@nonlinear-analytics.com or olga@deepquarry.com
© Francine McKenna, The Digging Company LLC, 2024
[1] I searched for text string “valuation allowance” and manually reviewed the output to remove false positives.