Are Your Deferred Tax Assets Properly Valued?

Companies with financial statements that are subject to GAAP accounting principles should measure valuation allowances against each deferred tax asset component on an ongoing basis. This should include considering whether deferred tax assets are properly valued each reporting period.

Depending on a company’s facts and circumstances, determining the need for and amount of a valuation allowance can be one of the most subjective and challenging aspects of income tax accounting for financial statement purposes.

Deferred tax assets arise when the financial accounting basis of an asset or liability differs from its tax basis. Deferred tax asset and liability balances represent a broad set of possible differences, including book and tax basis differences in accrued liabilities, fixed assets, intangibles, deferred revenue, net operating loss carryforwards, and many others.  Conceptually, this is similar to adjusting the value of goodwill for an impairment loss that adjusts its value to match its current market value.

When is a valuation allowance needed?

A valuation allowance is needed whenever a company believes, based on its analysis, that there is a 50% or less chance of realizing some or all of its deferred tax assets.  In making this determination, authoritative guidance requires that all available evidence be weighed and considered, including what gave rise to the asset as well as past, current and future business operations.

Because future taxable income is required to realize the benefit of a deferred tax asset, the analysis is intended to determine how much taxable income will be available in the future.  Taxable income can originate from a variety of sources including taxable income in prior year(s) if the deferred tax asset is permitted to be carried back under the tax law, future reversals of existing deferred tax liabilities, projected book income and permanent adjustments, and tax planning strategies.

Sometimes, after careful consideration of all available evidence, only a portion of a tax benefit for a deductible temporary difference or tax carryforward may be expected to be realized, resulting in a partial valuation allowance.

How does a valuation allowance analysis affect financial statements?

A valuation allowance can be the largest driver of the tax rate and cause significant swings of such rate year over year. In the year established, the valuation allowance increases tax expense and the effective tax rate, often significantly.  Subsequent adjustments and reversals may have material impacts.

Therefore, footnote disclosures should provide information regarding the company’s valuation allowance position and how it was evaluated.  Some of these disclosures include:

• Amount of the valuation allowance at year-end and the change in the valuation allowance during the year; and
• Sufficient disclosure to allow the reader to understand the evidence the company considered in determining the amount of deferred tax asset that will be realized and the valuation allowance recorded.

Because of the judgment and analysis involved, the existence or lack of a deferred tax asset valuation allowance often attracts audit and regulatory scrutiny and is a frequent source of comment letters from the SEC. Companies should carefully plan and document positions in advance of financial statement reporting deadlines.

For assistance with valuation allowance issues, contact us.

Authored by Deanna Johnson and Robert Henry

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