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SEC Insights - March 2010


Taking a Closer Look at Deferred Tax Assets



The past couple of years certainly have been challenging from a business perspective for companies in most sectors of the economy. Many companies which historically were profitable have experienced losses over the past 18 to 24 months. With the economy forecasted to be just at the beginning of a slow recovery, it would appear that the return to profitability for many companies may not occur in the near term. This has resulted in auditors asking questions regarding the recoverability of deferred tax assets that have been recorded on companies’ financial statements.

The evaluation of the recoverability of deferred tax assets is nothing new. Management has always had the responsibility to evaluate the recoverability of the deferred tax assets when issuing financial statements, but the current economic environment has made the evaluation process much more challenging. Auditors have been requiring companies to take a careful look at their deferred tax assets to determine whether a valuation allowance is warranted, especially if the company in question has suffered losses during the past couple of years. Additionally, if a certain level of losses have occurred there is a presumption that the deferred tax asset that has been recorded should be reduced by a valuation allowance.

Deferred tax assets are recognized for deductible temporary differences, operating losses and tax credit carryforwards. There also must be a determination by the company that there will be sufficient future taxable income to realize the related tax benefits that will reduce taxes that would otherwise be payable. A valuation allowance is required for deferred tax assets, if based on available evidence, it is more likely than not that that all or some portion of the asset will not be realized due to the inability to generate sufficient taxable income in the future.

Management needs to consider all positive and negative evidence when determining how much of a valuation allowance to recognize. A valuation allowance must be recognized when it is more likely than not that all or a portion of the deferred tax asset will not be realized. Changes in the valuation allowance caused by changes in circumstances that result in a change in judgment about the realizability of deferred tax assets are included as part of a company’s tax provision and generally reflected in income from continuing operations.

In order for companies not to establish or increase a valuation allowance that reduces their deferred tax assets, they need to evaluate the sources of taxable income that could be generated in sufficient amounts to realize the related benefits. There are four possible sources of taxable income that may be available to realize the benefit of deferred tax assets. They are as follows:

  1. Taxable Income in the Carryback Years if Permitted by Current Tax Law. Deferred tax assets are realizable if the future deductible amounts would, under the existing provisions of the tax law, result in future tax losses that can be carried back to recover taxes paid for the current year or prior years within the carryback period.
  2. Future Reversals of Existing Taxable Temporary Differences. Deferred tax assets are realizable if the future deductible amounts would reduce, under existing provisions of the current tax law, taxes that would be paid on future taxable income generated by existing taxable temporary differences.
  3. Tax Planning Strategies. Tax planning strategies may be available to accelerate or delay taxable income or deductions, change the character of taxable income or deductions, or switch from tax exempt to taxable investments so there would be sufficient taxable income of the appropriate character and in the appropriate periods to allow for the realization of the tax benefits of deductible temporary differences or carryforwards. Tax planning strategies are actions that an enterprise might take, but would likely only do so in order to realize the tax benefits.
  4. Future Taxable Income Exclusive of Reversing Temporary Differences and Carryforwards. Deferred tax assets are realizable against projected future taxable income.

In summary, the evaluation of deferred tax assets has probably not been an area of concern in the past, but with the economic events during the past couple of years and the economic environment that is expected, this could be a problem area for many companies in various industries.




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