Evaluating deferred tax assets.
The underlying principle of Statement no. 109 is that deferred tax assets and liabilities should be recognized for the future tax consequences of past events. Both are measured and recorded based on the expected tax consequences when the underlying temporary differences (book- versus tax-basis differences) generate taxable income or deductions in the future. In addition to temporary differences, deferred tax assets also are recognized for tax attributes such as operating and capital losses and tax credit carryforwards.
Future realization of the tax benefit of an existing deductible temporary difference or tax attribute carryforward depends on the existence of sufficient taxable income of the appropriate type within the appropriate periods. Under Statement no. 109, taxable income sources are
* Reversals of existing taxable temporary differences.
* Taxable income in carryback years.
* Expected future taxable income other than reversals.
* Tax planning strategies.
The first two sources are the most objectively determinable.
Negative evidence may create uncertainty about the availability of taxable income from any of these sources. For instance, a history of recent prior losses that creates uncertainty about future income suggests a valuation allowance may be required. In some circumstances, positive evidence can overcome this presumption. For example, prior losses may have been caused by conditions not expected to recur. To the extent deductible temporary differences can reduce or otherwise offset taxable temporary differences within the appropriate periods, no valuation allowance should be required and negative evidence need not be considered. Absent negative evidence, the more likely than not criteria should allow most profitable companies to recognize the full amount of any deferred tax assets.
A review of the financial statements of approximately 100 publicly held U.S. companies that have adopted Statement no. 109 shows 93 companies reported deferred tax assets and more than half of these recorded some amount of related valuation allowances. The financial statements disclosed these major sources of deferred tax assets:
* Other postretirement employee benefit accruals.
* Bad debt allowances.
* Inventory reserves and tax capitalized inventory costs.
* Restructuring reserves.
* Reserves for discontinued operations.
* Litigation reserves.
* Operating loss carryforwards (U.S., foreign and state).
* Capital loss carryforwards.
* Tax credit carryforwards.
A number of the companies that recorded valuation allowances were profitable and recorded deferred tax liabilities in excess of gross deferred tax assets. Generally, three factors caused these companies to record valuation allowances.
* Unique sources. Companies reported capital loss carryforwards, foreign tax credits and other potential future tax benefits that require unique types of future taxable income for realization or which have relatively limited carryforward or carryback periods.
* Jurisdictional issues. Companies had net operating loss carryforwards and future deductible temporary differences in one or more jurisdictions (among different states within the United States or foreign countries) with profits and deferred tax liabilities in other jurisdictions.
* Unique timing issues. Companies reported temporary basis differences that have unique reversal patterns giving rise to deductions not expected to occur until far beyond the reversal of existing taxable differences.
COMPANIES WITH A HISTORY OF PROFITS
Companies that historically have generated taxable income may not need to make detailed calculations to evaluate deferred tax assets. Some basic knowledge of the overall turnaround period of deferred tax assets may be required, however, to compare with
* Reversals of existing taxable temporary differences.
* Taxable income in carryback years.
* Expected future taxable income from other sources.
For the most part, companies with a history of profits and whose deferred tax items arise from ordinary income-type temporary differences will not need to consider tax-planning strategies.
Example: Robust Company has gross deferred tax assets of $350,000 related to $1,030,000 of warranty reserves expected to produce tax deductions ratably over the next five years. Robust also has deferred tax liabilities of $400,000 related to $1,175,000 of property and equipment basis differences expected to generate taxable income ratably over the same period.
Realization of the entire deferred tax asset can be justified because
* Taxable temporary differences exceed deductible temporary differences by $145,000 ($1,175,000 less $1,030,000).
* All temporary differences will turn around at the same relative rate for the same number of years.
If they do not have sufficient taxable temporary differences, profitable companies can rely on taxable income in carryback years or expected future taxable income other than reversals. Assume Robust Company has no deferred tax liabilities but reported ordinary taxable income of approximately $300,000 per year for the last six years. Realization of the entire deferred tax asset can be justified because
* Even without considering future taxable income, expected tax deductions of $618,000 ($206,000 per year for the next three years) can be realized under the three-year carryback provisions.
* Expected future taxable income should easily exceed $206,000 per year, exclusive of reversing temporary differences based on the company's prior earnings record.
Assuming a 15-year carryforward period, even marginal expected future taxable income would justify recognition of the entire deferred tax asset.
COMPANIES WITHOUT A HISTORY OF PROFITS
For companies with no history of profits, conclusions about the need for and the amount of deferred tax asset valuation allowances require some calculations. Companies with negative evidence, such as a history of recent prior losses, may first want to look at taxable income that may exist in carryback years. Negative evidence must be evaluated when looking at reversals of existing taxable temporary differences and, if necessary, future taxable income other than reversals. A history of losses (negative evidence) may not rule out recognition of deferred tax assets. A company with such a history may have offsetting positive evidence, such as a decision to eliminate an unprofitable operation or an increased sales backlog. Companies in this situation will be much more likely to consider tax-planning strategies.
Example: On-The-Edge Company has taxable temporary differences related to property and equipment that are expected to generate annual taxable income of approximately $25,000 in years one through four. In addition, On-The-Edge has deductible temporary differences related to warranty reserves of $60,000 expected to generate tax deductions of $25,000 in year two and $35,000 in year three. Assuming a three-year carryback period for operating losses, this example shows that the benefit of the future tax deduction is assured through reduction of future taxable income generated by reversals of existing taxable temporary differences (see exhibit 1, page 73).
In this example, no consideration was given to anticipated future results of operations. Whether the company anticipates future taxable income, breakeven or even future tax losses has no bearing on realization of the deferred tax assets in this example. The turnaround of existing taxable amounts equals or exceeds that of existing deductible amounts within the appropriate time periods. Once this source of taxable income satisfies realization, no additional evidence needs to be examined.
Example: Assume that in addition to the warranty reserve, On-The-Edge has a $35,000 net operating loss carryforward expiring in year 10. Future tax deductions total $95,000 ($60,000 of warranty reserves and $35,000 net operating loss carryforward) and future taxable amounts total $100,000 ($25,000 each in years one through four). The $35,000 operating loss carryforward can offset $25,000 of future taxable income related to property and equipment in year one and the remaining $10,000 of carryforward can be used to reduce future taxable income in year four along with the $10,000 operating loss generated in year three, as shown in exhibit 2, below.
In evaluating the realization of deferred tax assets in light of the reversal of existing deferred tax liabilities, it is important to have a general knowledge of the years in which the reversals will occur. If future deductible temporary differences will reverse too far into the future, they may not be available to offset taxable temporary differences that reverse during the carryback and carryforward periods.
Example: Dark Cloud Company has $100,000 of future taxable temporary differences related to property and equipment of $100,000 which are expected to generate taxable income of $50,000 in years one and two. The company has a $75,000 litigation accrual expected to result in a tax deduction in year five. Even though future taxable income amounts exceed future tax deductions, this pattern assures realization of only $50,000 of the future tax deduction (carryback from year five to year two). Absent sufficient future taxable income or the existence of viable tax-planning strategies, a valuation allowance may be required for the tax effect of the remaining $25,000 deductible amount. As previously mentioned, even companies with a history of operating losses may be able to recognize deferred tax assets if they can overcome the negative evidence with positive evidence.
Example: High Tech Company, a start-up company, has incurred substantial research and development costs in its first three years of operation, creating a $300,000 net operating loss carryforward. In the current year, product development is complete and the company has a significant backlog of orders for the new product, which exhibit 3, below, shows is expected to generate future taxable income of about $200,000 per year.
On the basis of forecasted future taxable income, High Tech can use all of its net operating loss carryforward by year two. Absent further negative evidence, a valuation allowance does not appear to be required. That conclusion, however, depends on the reliability of the forecast. In addition to the future revenue generated by the backlog, the company needs to forecast its manufacturing and other operating costs. Uncertainties inherent in forecasts, especially for start-up companies, may suggest an allowance is needed for some or all deferred tax assets until more operating experience is gained.
Deferred tax assets are measured for the estimated future tax effects of temporary differences and carryforwards. In addition to ordinary income sources, it's possible to generate deferred tax assets from capital loss and tax credit carryforwards or from an excess of tax over book basis in an existing capital-type asset, such as an unrealized loss on a stock investment. To derive a benefit from a capital loss carryforward, a company must anticipate it will be able to generate a sufficient amount of net capital gains during the carryforward period (five years under current federal tax law).
Example: Investor Company has a $550,000 capital loss carryforward that expires at the end of year two. The company has a $187,000 deferred tax asset and an equal amount of valuation allowance. In the current year (year one), the company generated an unexpected capital gain of $1 million, which qualifies for installment gain treatment and thus will be recognized ratably over four years, as shown in exhibit 4, page 77.
Assuming no alternative minimum tax (AMT) consequences, if Investor reports the gain on the installment basis, $250,000 of the capital loss carryforward is used in the current year and only $250,000 of the remaining $300,000 capital loss carryforward can be used in year two. At the end of year one, the company reduces gross deferred tax assets to $102,000 and its valuation allowance to $17,000, assuming no other negative evidence. The company also records a $255,000 deferred tax liability related to the deferred installment gain that ultimately will enter taxable income in years two to four. The net deferred tax expense for the current year is $170,000 ($255,000 less $102,000 plus $17,000). If the company elects out of the installment method and reports the entire gain in the current year, no deferred tax assets or liabilities exist and a current federal income tax provision of $153,000 is recorded in connection with the net gain. In electing this approach, however, Investor foregoes the time-value-of-money benefit of deferring the gain.
The AMT provides another example of unique sources of deferred tax assets. AMT calculations can create AMT credit carryforwards or can limit use of other credit carryforwards, such as research or foreign tax credits. Since the AMT credit carryforward period is unlimited, most companies (with some notable exceptions) can assume they eventually will become regular tax paying entities. Since the AMT credit can reduce a company's tax liability only to the extent of that year's AMT, the ability to realize the AMT credit in its entirety still depends on some expected level of future taxable income.
Foreign tax credit (FTC) carryforwards create particularly complex valuation issues; they can be used only to reduce taxes on foreign source income such as dividends from foreign subsidiaries. Companies with FTC carryforwards must assess their ability to generate the appropriate type of future net foreign source income. Generally, companies may consider future taxable foreign source income, such as repatriation of accumulated earnings of foreign subsidiaries, only to the extent U.S. deferred tax liabilities have been recorded on those earnings.
Statement no. 109 requires deferred tax assets and liabilities be calculated on a jurisdictional basis. Companies profitable on a consolidated basis may have unprofitable or marginally profitable operations in certain jurisdictions, creating the potential for valuation allowances. This situation can occur if a company has operations in more than one state, has foreign operations or does not include all of its domestic operations in its consolidated U.S. federal tax return.
Tax-planning strategies may ensure that jurisdictional losses ultimately are realized. Companies may be able to modify transfer pricing or other intercompany fee arrangements to shift income from one jurisdiction to another. The viability of any strategy depends on the tax laws in each affected jurisdiction. Most jurisdictions closely scrutinize intercompany transactions that reduce taxable income.
UNIQUE TIMING ISSUES
Pension obligations, deferred compensation arrangements and other postretirement benefits are examples of deductible temporary differences that may not result in tax deductions until some distant future date. When tax deductions begin, they may continue for many years. A significant amount of these deductible temporary differences may reverse in periods when all currently existing deferred tax liabilities have already resulted in taxable income, eliminating one source of taxable income-reversals of existing taxable temporary differences.
Companies with a history of more than marginal profits and with no negative evidence should be able to assume, for Statement no. 109 purposes, that those profits will continue far enough into the future to realize all deferred tax assets regardless of how long that may take. On the other hand, marginally profitable companies or those in industries where future long-term earnings are likely to be depressed by significant changes should probably consider establishing valuation allowances on some portion of long-term reversals of deferred tax assets.
Statement no. 109 introduced subjectivity into the measurement and evaluation process of determining deferred taxes. Subjectivity does not extend to the measurement and evaluation procedures as much as it does to weighing the reasonableness and relevance of the data obtained. Companies with no history of strong earnings will need to develop an evaluation process that gathers sufficient reasonable positive evidence to outweigh any existing negative evidence.
RELATED ARTICLE: EXECUTIVE SUMMARY
* IMPLEMENTATION OF FINANCIAL Accounting Standards Board Statement no. 109, Accounting for Income Taxes, can be problematic because of the subjectivity of determining if it is "more likely than not" that an entity's deferred tax assets will be realized.
* THE FINANCIAL STATEMENTS OF approximately 100 publicly held U.S. companies that have already adopted Statement no. 109 indicate 93 have reported deferred tax assets on their financial statements and more than half recorded a related valuation allowance.
* COMPANIES THAT HISTORICALLY have generated taxable income may not have to make detailed calculations to evaluate deferred tax assets. Companies with no history of profits must perform some calculations to support conclusions about the need for and the amount of deferred tax asset valuation allowances.
* THREE FACTORS MAY CAUSE companies to record valuation allowances, including the existence of unique sources of taxable income, jurisdictional issues (multistate or foreign operations) and matters of the timing of income and deductions.
THOMAS R. PETREE, CPA, is a partner of Wagner Sharer & Co., Malvern, Pennsylvania. He is a member of the American Institute of CPAs and served on the Financial Accounting Standards Board implementation group for Statement no. 109. GEORGE J. GREGORY, CPA, is a tax partner of Coopers & Lybrand, LLP, Philadelphia. An adjunct professor at Temple University in Philadelphia, he is a member of the AICPA and the Pennsylvania Institute of CPAs. RANDALL J. VITRAY, CPA, is a partner of Coopers & Lybrand in Philadelphia. He is a member of the AICPA and the PICPA.
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|Author:||Vitray, Randall J.|
|Publication:||Journal of Accountancy|
|Date:||Mar 1, 1995|
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