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FASB 109: auditing considerations of deferred tax assets.

There are no magic formulas for determining the need for a valuation allowance.

In February 1992, the Financial Accounting Standards Board issued Statement no. 109, Accounting for Income Taxes, which requires a revised version of the asset-liability method of interperiod income tax allocation. Statement no. 109 supersedes Statement no. 96 of the same name, which requires another version of the asset-liability method, as well as Accounting Principles Board Opinion no. 11, also of the same name, which requires the deferred method of interperiod income tax allocation.

Both versions of the asset-liability method are balance-sheet-oriented-deferred tax assets and liabilities are recognized for the tax effects of temporary differences. They differ from the deferred method, which is income-statement-oriented - deferred tax debits and credits are recognized for the tax effects of timing differences.

A major difference between the two asset-liability methods relates to deferred tax assets. Statement no. 96 prohibit recognizing deferred tax assets unless they are realizable by carryback or offset, which was criticized because it leads some companies to report unrealistic amounts - such as zero deferred tax assets - when realization is probable but not by carryback or offset. Statement no. 109 requires recognizing deferred tax assets if realization is more likely than not. This article summarizes the auditing considerations of applying the more-likely-than-not test.


Under Statement no. 109, deferred tax assets are determined separately from, deferred tax liabilities. All deferred tax assets are initially recorded and evaluated for realization based on the weight of available evidence. The more negative evidence that exists, the more positive evidence is needed to avoid recording a valuation allowance. A valuation allowance is required if it is more likely than not (defined as a likelihood of more than 50%) the deferred tax asset will not be realized. This test is the same for deferred tax assets arising from deductible temporary differences or operating loss and tax credit carryforwards.

If there is no negative evidence, audit testing need not be extensive. If the client is historically very profitable and pays taxes, the auditor may assume the situation will continue, absent knowledge to the contrary. The auditor normally documents that he or she is relying on future income expectations based on past experience and concludes a valuation allowance is not necessary. Reviewing a budget, analysis or forecast of future taxable income normally is not required.

As the weight of negative evidence increases, the need for positive evidence increases in greater proportion and the amount of evidential matter and the extent of audit testing also increase. Judgment about the extent of testing, evidential matter and the need for a valuation allowance depends on each client's specific facts and circumstances. There are no magic formulas for determining if, or in what amount, a valuation allowance is needed. The following guidance was developed assuming negative evidence exists, although in many situations this is not the case.


Future realization of deferred tax assets ultimately depends on having sufficient taxable income of the appropriate type (ordinary income or capital gain) within the carryback or carryforward periods. The only possible taxable income sources that may be available to realize a future tax benefit for deductible temporary differences and carryforwards are

* Taxable income in prior carryback years.

* Taxable income from reversals of existing taxable temporary differences.

* Taxable income from tax planning strategies that can be implemented, if necessary, to avoid losing the benefit of the deferred tax asset.

* Expected future taxable income, exclusive of reversing temporary differences and carryforwards.

The availability of each of these sources may vary for different tax jurisdictions and from year to year in a particular jurisdiction.

If a deferred tax asset cannot be, fully realized from either carryback or offsetting sources, future taxable income and tax planning strategies should be considered. If a valuation allowance is recorded, all four taxable income sources must be considered to avoid overstating the allowance. In all cases, the auditor should document the rationale for the valuation allowance or for the conclusion no allowance is required.

When the reasonableness of management's valuation allowance, if any, is evaluated, the guidance in Statement on Auditing Standards no. 57, Auditing Accounting Estimates, should be considered. SAS no. 57 requires the auditor to use one or more of the following approaches to evaluate management's estimate:

* Review and test the process management used to develop the estimate.

* Develop an independent expectation of the estimate to corroborate the reasonableness of management's estimate.

* Review subsequent events or transactions occurring before the fieldwork is completed.

The audit approach used in evaluating management's determination of the valuation allowance, if any, depends on the facts and circumstances, particularly the source(s) of future taxable income. Of the four taxable income sources, carryback and offsetting income are more reliable forms of evidential matter and therefore ordinarily should be considered first. If deferred tax assets can be fully realized from these sources, there is no need to evaluate the likelihood other taxable income sources exist to support the conclusion a valuation allowance is not needed.

Taxable income in prior carryback years, When using carryback taxable income, a general understanding of the pattern and timing of the reversal of existing temporary differences is necessary. If an entity had taxable income in the carryback period, this income will be available to realize the tax benefits of deductible temporary differences only if the differences become deductible in a period permitting carryback. For example, a deductible difference reversing four years from the balance sheet date cannot be realized by carryback, given the three-year carryback limit under current U.S. tax law.

Reversal of existing taxable temporary differences. Like carrybacks, offsetting the reversal of existing deductible temporary differences against the reversal of taxable temporary differences requires knowing the pattern and timing of the reversal. For example, future taxable temporary differences reversing 20 years after the balance sheet date cannot offset deductible temporary differences reversing within 4 years of the balance sheet date because the carryforward period generally is 15 years under U.S. tax law.


If carryback or offsetting sources are not sufficient, tax planning strategies and future taxable income excluding reversing temporary differences are then considered. Tax planning strategies are defined by Statement no. 109 as prudent and feasible actions management would implement, if necessary, to prevent the expiration of a carryforward. Tax planning strategies also require a knowledge of the pattern and timing of the reversal of existing temporary differences.

Management has primary responsibility for determining that tax planning strategies are prudent and feasible. The auditor's responsibility is to determine the strategy is reasonable based on his or her knowledge of the entity's business and operations. Although a tax planning strategy may have adverse consequences, it still may be prudent if it will prevent a loss carryforward from expiring unused. The mere fact management can generate taxable income and use a carryforward by implementing a strategy does not make the strategy prudent, particularly if there are adverse consequences.

A diversified company, for example, can sell a profitable segment but it may not be prudent to do so if the segment is responsible for distributing the company's product. Similarly, a bank may sell its lease portfolio or credit card business, or a mining company with several mines may sell one. But a strategy is not prudent if it would jeopardize a company's existence.

For a strategy to be feasible, it must be within management's primary (but not necessarily unilateral) control. For example, if no ready market exists, a strategy to sell an asset is not feasible. Management also should consider whether a loan covenant or required regulatory or board of directors' approval affects a tax planning strategy's feasibility.

Evaluating a tax planning strategy includes considering evidence of whether the strategy will produce sufficient taxable income and may include an independent appraisal, a quoted market price or a comparable recent sale. When the auditor performs a valuation study, he or she must make clear the client has accepted the valuation as its own. The client must understand and accept the study's concepts, assumptions, approach and findings. If not, there could be an auditor independence issue.

For many strategies, the timing necessary to implement them also may affect their prudence and feasibility. A strategy may meet the prudent and feasible criteria currently but may not be implemented until some future year. The auditor can rely on that strategy today, provided it is not contradicted by existing facts, including facts known today about the future; the strategy should be reevaluated at each subsequent reporting date.


Absent the other three taxable income sources, expected future taxable income (excluding reversing temporary differences and carryforwards) should be considered in assessing the need for a valuation allowance. Management has the primary responsibility to estimate future taxable income; its letter of representation should acknowledge this responsibility. The auditor should be cautious when helping management prepare the estimate; doing so may impair the auditor's independence.

It may be useful for management to refer to the American Institute of CPAs Guide for Prospective Financial Statements. However, Statement no. 109 does not require either a financial forecast or a projection, as these terms are defined in the AICPA statements on standards for accountants' services on prospective financial information.

Management's analysis of future taxable income should identify all major assumptions and be in sufficient detail to support its completeness. The more substantive an entity's analysis of the major assumptions and the more reasonable the assumptions, the more, weight it may be given. Independent third-party assessments of the client and the industry, such as AICPA audit risk alerts, other industry surveys and those in business periodicals, should be considered. If the company is publicly held, the auditor also should read reports prepared by external financial analysts.

Regardless of how substantive an entity's analysis of future taxable income is, the auditor should consider whether management has an objective basis to prepare the analysis. For example, the auditor should consider management's expertise in preparing such analyses and the reasonableness of previous analyses. An entity in a relatively stable industry with mature product lines and a stable operating history is more likely to have an objective basis than one in an emerging industry with untested technology and little or no operating history. The auditor should determine the major assumptions underlying the analysis are suitably supported. Particular attention should be paid to assumptions material to the analysis of future income, especially those susceptible to change or inconsistent With historical trends.


Statement no. 109 says "all available evidence, both positive and negative, should be considered in determining whether, based on the weight of that evidence, a valuation allowance is needed." Evidence is weighed based on "the extent to which it can be objectively verified." The more negative evidence, the more positive evidence is needed and the more difficult it is to conclude a valuation allowance is not needed for all or part of a deferred tax asset.

Of the negative evidence cited in Statement no. 109, the most prominent is the example of cumulative losses in recent years. Other negative evidence cited in the statement includes

* A history of operating loss or tax credit carryforwards expiring unused.

* An expectation of losses in early future years (by a currently profitable entity).

* Unsettled circumstances that, if unfavorably resolved, will adversely affect operations and profit levels on a continuing basis in future years.

* A carryback-carryforward period that is so brief it would limit realization of tax benefits if

1. a significant deductible temporary difference is expected to reverse in a single year or

2. the enterprise operates in a traditionally cyclical business.

Besides the negative evidence cited in Statement no. 109, SAS no. 59, The Auditor's Consideration of an Entity's Ability to Continue as a Going Concern, notes conditions and events constituting other negative evidence that should be considered when evaluating the need for a valuation allowance, including

* Negative trends, such as recurring operating losses, working capital deficiencies, negative cash flows from operating activities and adverse key financial ratios.

* Other indications of possible financial difficulties, including defaults on loans or similar agreements, dividend arrearages, denials of usual trade credit from suppliers, restructuring of debt, noncompliance with statutory capital requirements and the need to seek new sources or methods of financing or to dispose of substantial assets.

* Internal matters, such as work stoppages or other labor difficulties, substantial dependence on particular projects' success, uneconomic long-term commitments and the need to significantly revise operations.

* External matters that have occurred, including legal proceedings or legislation, that might jeopardize an entity's ability to operate; losses of key franchises, licenses or patents; losses of principal customers or suppliers or uninsured or underinsured catastrophes such as droughts, earthquakes of floods.

Statement no. 109 cites the following examples (not prerequisites) of positive evidence that may offset negative evidence when determining if a valuation allowance is needed:

* Existing contracts or firm sales backlogs that will produce more than enough taxable income to realize the deferred tax asset based on existing sales prices and cost structures.

* An excess of appreciated asset value over the tax basis of net assets in an amount sufficient to realize the deferred tax asset.

* A strong earnings history exclusive of the loss that created the future deductible amount (tax loss carryforward or deductible temporary difference) coupled with evidence indicating the loss (an unusual, infrequent or extraordinary item) is an aberration rather than a continuing condition.

If an entity does not have substantial negative evidence, substantial positive evidence of future taxable income is not needed. On the other hand, if an entity has substantial negative evidence, a forecast of taxable income by itself does not provide sufficient positive evidence to outweigh the negative evidence. Most negative evidence involves past events and is objectively verifiable; a forecast of taxable income in not. Because the weight given the potential effect of negative and positive evidence is commensurate with the extent it can be objectively verified, reliance solely an expected future taxable income rarely overcomes substantial negative evidence and supports a conclusion no valuation allowance is necessary.


If the auditor's report includes a paragraph discussing substantial doubt about the entity's ability to continue as a going concern, a valuation allowance is probably required for deferred tax assets not assured of realization by carrybacks or reversals of taxable temporary differences.

In general, the Securities and Exchange Commission will not accept an auditor's report modified for asset realization uncertainty unless the uncertainty is due to a going-concern situation. For private companies, the Statement no. 109 approach for recognizing a valuation allowance usually precludes an auditor's report modified for uncertainty about deferred tax asset realization. Since Statement no. 109 uses a more-likely-than-not criterion to assess the need for a valuation allowance, an auditor's report modification for uncertainty about realization of deferred tax assets usually contradicts the enterprise's assessment of realization.

In addition to going-concern considerations, certain types of entities would, by their nature, generally require a valuation allowance. For example, start-up operations and developing companies generally require a valuation allowance for all deferred tax assets that are not assured of realization by either carryback to prior tax years or reversals of existing taxable temporary differences.


The representation letter should note management's responsibility to determine the amount of the valuation allowance and to identify prudent and feasible tax planning strategies and estimate future taxable income, excluding reversals. SAS no. 61, Communication With Audit Committees, directs the auditor to ascertain the audit committee is informed of the process management uses to formulate key accounting estimates and if tax planning strategies are relied on to determine the valuation allowance.


Statement no. 109 is effective for fiscal years beginning after December 15, 1992, with initial application as of the beginning of an entity's fiscal year for both annual and interim financial reporting purposes. Earlier application is encouraged. Because realizability of deferred tax assets may depend on future taxable income and the availability of tax strategies, both management and the auditor should assess these factors immediately to avoid last-minute implementation problems.
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Author:Nurnberg, Hugo
Publication:Journal of Accountancy
Date:May 1, 1993
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