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Recognizing Valuation Allowances for Deferred Tax Assets

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You are preparing your company’s year-end tax provision.  Consolidated taxable income includes a small profit, and the company has net operating losses from prior years.  The deferred roll-forward schedule shows a debit balance.  You request a five-year income statement forecast from the finance group, which shows small amounts of projected profit each year.  So, you ask yourself, “Will the company utilize all existing deferred tax assets (DTAs) in the future?” 

 If not, you’ll need to recognize a valuation allowance. Under ASC 740, a company must reduce the value of deferred tax assets if it is more likely than not that those deferred tax assets are not expected to be realized in the future. That reduction is called a valuation allowance. Remember, deferred tax assets represent future tax deductions, so they will reduce any projected future book profits.  If that answer is ‘no’, then the amount of DTAs must be offset by the recognition of a valuation allowance, or perhaps, a partial valuation allowance.   

 How Do You Calculate a Valuation Allowance? 

Consider all available evidence to determine whether a valuation allowance for DTAs is needed. Gather as much data as possible, including the company’s current financial position, prior years’ income statements/tax returns, and any forecasts of future financial performance. 

 Analyze all information to determine whether the company will be able to realize any of its existing deductible temporary differences and/or carryforwards—schedule out the reversal of timing differences. Ultimately, this will depend on the existence of sufficient taxable income within the carryback or carryforward period available under the tax law.   

Consider tax-planning strategies that could be implemented. Tax planning typically has the goal of reducing future taxable income and tax liabilities.  However, in some cases, tax planning can take the form of accelerating taxable income into the short term to utilize cumulative losses and credit carryforwards and/or offset the reversal of deductible temporary differences.  Consider whether a change of accounting method or foregoing immediate expensing of fixed assets would benefit the short-term calculations. 

 If projected future taxable profits are sufficient to utilize all carryforwards and cover the reversal of all DTAs, then no valuation allowance is required. However, if this is not the case, then analyze all evidence available to determine whether a valuation allowance is necessary, and if so, how much.  Forming a conclusion that a valuation allowance is not needed is difficult when there is negative evidence such as cumulative losses in recent years.  

 Factors to Analyze:  

a. Existing contracts or sales backlog that will produce more than enough taxable income to realize the deferred tax assets based on existing sales prices and cost structures;

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

c.  Losses expected in early future years (especially by a currently profitable entity);

d.  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;

e. Unsettled circumstances that, if unfavorably resolved, would negatively affect future operations and profit levels on a continuing basis in future years;

f.  A carryback, carryforward period that is so brief it would limit the realization of tax benefits if a significant deductible temporary difference is expected to reverse in a single year or the entity operates in a traditionally cyclical business;

g.  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 that the loss (for example, an unusual or infrequent item) is an aberration rather than a continuing

 All this boils down to a judgment call. Remember, this is a “more likely than not” determination— you believe that it is more likely than not (greater than 50% likelihood) that your company will be able to realize some/all deferred tax assets in the future. This is a management assertion, so be certain that the CFO, head of finance, etc. are on board and agree with your conclusion.  Consider consulting with your tax advisors. 

 Document, document, document—Make sure to carefully document your position.  Write a detailed memo.  Prepare and include all supporting schedules and calculations.  Your auditors will scrutinize your conclusion in great detail before signing off, so be certain you have all of your ducks in a row.