Can SEC inquiries explain Tesla's release of $5.9 billion tax valuation allowance?

SEC issued comment letters to Tesla questioning accounting for tax valuation allowance. The review concluded just one day after the earnings release.

Companies make substantial changes in their accounting and disclosure in response to SEC comment letters, and academic literature confirms that¹. A material and unexplained accounting change may mean a regulatory voice has been loudly whispering behind the scenes.

Tesla’s release of $5.9 billion of its deferred tax asset valuation allowance, disclosed on January 24, 2024, fits this pattern. The change was material and the timing of the release was initially puzzling. A lack of a bright-line accounting guidance allows flexibility and leaves room for judgment calls to decide when the valuation allowance should be released.

A deferred tax asset reflects the likely benefit a firm can use in a future period to reduce or eliminate a future tax liability. A valuation allowance offsets the deferred tax asset if the future benefits are not sufficiently certain. If a firm is not likely to have future taxable income, it must record a valuation allowance against the deferred tax asset and recognize an expense.

It’s the “not likely” part that allows for judgment in establishing the valuation allowance and its corollary, “more likely than not”, that allows judgment on the timing of a reversal. As reported by Bloomberg:

Companies reduce the reserve they set aside to cover unrealized tax benefits when it’s “more likely than not” that they will use their tax benefits. They assess things like their loss history, tax benefits related to stock-based pay, and tax planning strategies until there’s enough evidence that they’ll take advantage of past losses to reduce their future bills.

Since Tesla historically recorded a nearly 100% valuation allowance on its deferred tax assets, it did not have the big hit to net income many others had when the assets were revalued because of tax reform in 2018. As reported by MarketWatch :

Tesla doesn’t have to worry about a big hit to its bottom line as a result of tax reform because the company has already written down the value of its large deferred tax assets, telling investors in its last annual report they don’t know when they will be profitable enough to ever use them.

So, why did Tesla reverse its nearly 100% valuation allowance now?

The answer is in the SEC’s comment letters, that were only just made public. The SEC questioned Tesla’s accounting for tax valuation reserves during a review that spanned more than 121 days (compared to an average of 30 to 40 days for all companies) with seven back-and-forth letters, and including two extensions of time requested by Tesla. The review started on September 26, 2023, and concluded on January 25, 2024 – just one day after Tesla’s earnings call that disclosed the release of the valuation allowance.

As Nicola White reported for Bloomberg on February 23, 2024 – with my quote included – the timing was not coincidental:

The timing of the SEC wrapping up its review — one day after Tesla took the action the SEC first scrutinized — is not a coincidence, said Olga Usvyatsky, an accounting consultant and former vice president of research at Ideagen AuditAnalytics.

“I’ve seen more than once a pattern of the SEC issuing pointed, carefully phrased comments that, after reviewing relevant accounting guidance, lead the company to agree with the accounting treatment suggested by the SEC,” Usvyatsky said.

Let me provide more context to my Bloomberg's quote.

In one of the questions, the SEC requested clarity about factors used by Tesla to conclude that maintaining full valuation allowance is appropriate:

We note your earnings history, including significant pre-tax income in each of the three years presented within your consolidated statements of operations. We also note your disclosure on page 82 that you intend to continue maintaining a full valuation allowance on your U.S. deferred tax assets until there is sufficient evidence to support the reversal of all, or some portion, of your valuation allowance. Please tell us, and revise your disclosure in future filings to clarify, what you mean when you state “... we intend to continue maintaining a full valuation allowance on our U.S. deferred tax assets until there is sufficient evidence to support the reversal of all or some portion of these allowances. In this regard, reconcile your disclosure to the “more-likely-than-not” recognition threshold within ASC 740-10-30, or revise to eliminate the ambiguity.

Note that the SEC mentioned “significant pre-tax income in each of the three years…” presented in the income statement. In a follow-up letter, the SEC also asked Tesla to explain whether a one-year forecast is sufficient to determine that tax benefits are not realizable.

This specific, targeted language — along with the underscoring used by the SEC to highlight the phrase “sufficient evidence” — suggests that the SEC sought company-specific, detailed evidence supporting the decision to maintain the full tax valuation allowance reserve despite the recent pattern of pre-tax profits. On the other hand, insufficient evidence would have forced Tesla to reverse the tax valuation reserve or even restate previously filed financial statements if the SEC believed the allowance should have been released earlier.

While Tesla de facto agreed with the SEC’s position and released the allowance in the fourth quarter of 2023, Tesla never attributed the change to SEC comments. The lack of attribution is hardly a surprise since managers have no incentive to disclose the regulatory reviews or acknowledge that SEC inquiries prompted the change.

However, the lack of acknowledgment of the expected accounting change in the Company’s written responses to the SEC (filed as CORRESP on EDGAR) is interesting. For instance, if a company agrees to make a substantial accounting change in response to SEC comments, it may respond to the SEC by stating that it will make the change prospectively in the next quarterly (or annual) period.