Must a valuation allowance be recorded against a deferred tax asset?

Companies are facing more scrutiny than ever about whether a valuation allowance should be recorded against their deferred tax assets and, if so, when. Auditors face challenges when evaluating the appropriateness of a company's position on these allowances.

A valuation allowance should be recorded against a deferred tax asset if, based on the weight of available evidence, it is more likely than not that some portion (or all) of the deferred tax asset will not be realized. The more-likely-than-not standard is widely defined as a likelihood of more than 50%.

Evidence

Financial Accounting Standards Board (FASB) Statement No. 109, Accounting for Income Taxes, [paragraph] 20, sounds simple: "All available evidence, both positive and negative, should be considered to determine whether, based on the weight of that evidence, a valuation allowance is needed."

Negative evidence: This include, but is not limited to, cumulative losses in recent years; a history of operating loss or tax credit carryforwards expiring unused; losses expected in early future years (by a presently profitable entity); unsettled circumstances that, if unfavorably resolved, would adversely affect future operations and profit levels on a continuing basis in future years; or brief carryback or carryforward periods that would limit realization of tax benefits.

Positive evidence: This includes, but is not limited to, existing contracts or firm sales backlog that will produce more than enough taxable income to realize the deferred tax asset based on existing sales prices and cost structures; or an excess of appreciated asset value over the tax basis of the entity's net assets in an amount sufficient to realize the deferred tax asset or a strong earnings history, exclusive of the loss that created the future deductible amount, coupled with evidence indicating that the loss is an aberration, rather than a continuing condition.

Analysis

Four sources of taxable income can determine the possible future realization of the tax benefit of an existing deductible temporary difference or carryforward:

1. Future reversals of existing taxable temporary differences.

2. Future taxable income exclusive of reversing temporary differences and carryforwards.

3. Taxable income in prior year(s) if carryback is permitted under the tax law.

4. Tax-planning strategies that could, if needed, be implemented to:

* Accelerate taxable amounts to use expiring carryforwards;

* Change the character of taxable or deductible amounts from ordinary income or loss to capital gain or loss; or

* Switch from tax-exempt to taxable investments.

(Note: Caution is needed when evaluating the use of any tax-planning strategies.)

Significant judgment is required to evaluate the weight of positive and negative evidence; there must be objective, verifiable information to determine if a valuation allowance is needed. Evidence of recent actual historical losses is relatively concrete compared to budgeted or forecasted income, especially when a company's forecasting ability is suspect. Analysis should document the evaluation of all available evidence and rank it according to its ability to be objectively verified.

Conclusion

A company should document its need for a valuation allowance with detailed analysis and evidence on a jurisdictional basis at least annually for nonpublic companies and quarterly for public companies. The analysis should include the application of the rules outlined earlier, as well as specific guidelines from FASB Statement No. 109. The company's auditing firm will require this information; in addition, if the company is examined by the Public Company Accounting Oversight Board, the information will likely also be needed as evidence of audit procedures.

FROM SCOTT F. GUERTIN, CPA, BOSTON, MA