Auditors Take Closer Look at Deferred Tax Assets

  With losses mounting at many companies and forecasts offering scant hope for recovery, auditors are starting to ask hard questions about the deferred tax assets companies are reporting. “This is definitely a big problem for companies right now,” says Rick Martin, vice president at Pluris Valuation Advisors. A deferred tax asset is an asset on a company’s balance sheet based on the company’s expectation of a tax benefit to be claimed in the future. Its represents future deductions or net operating losses that can be carried forward to offset future earnings. Such assets arise because of differences between tax rules and accounting rules. “A deferred tax asset is a timing difference,” Martin says. “Maybe you can realize a tax benefit now for book purposes, but for tax purposes you have to wait. While you’re waiting you hang it up on your balance sheet as an asset until you can use it later.” The catch? That expectation of future earnings. Deferred tax assets are realized when companies record taxable income, and they generally expire after a few years depending on the specific tax rules that gave rise to the asset in the first place. “The Big 4 firms generally say if you have a certain level of losses historically, that casts doubt on whether you will be able to realize that asset in the future,” Martin says. “These deferred tax assets don’t last forever.” The problem is acute for financial institutions that are now fiercely defending value in toxic loan portfolios, Martin says. A writedown in loan values would prompt a writedown in deferred tax assets (also called a valuation allowance), which wrings value out of the balance sheet and becomes a charge to the income statement. But the deferred tax asset problem goes well beyond the battered banking sector. “Almost every company is going to be affected,” says Jose Lamela, managing director with consulting firm Alvarez & Marsal Taxand. “There are many reasons a company could have a deferred tax asset. It’s almost universal. If you have deferred tax assets, you have to look at whether there is a need for a valuation allowance.” “The macroeconomic pressure on deferred tax assets is forcing companies to reevaluate the likely usefulness of these assets on the balance sheet.” —Rich Walton, Tax Lawyer, Buchalter Nemer Accounting guidance on deferred tax assets and valuation allowances generally is found in the Accounting Standards Codification under Topic 740, Income Taxes (existing in past life as Financial Accounting Standard No. 109, Accounting for Income Taxes). According to Jeff Sanders, a partner at Texas-based auditing firm Weaver and Tidwell, auditors are encouraging companies to take a careful look at their deferred tax assets and to determine whether a valuation allowance is warranted. “The biggest thing that is explicit in the rules: If a company has cumulative losses in recent years, then it would be unlikely to not have a valuation allowance in that situation,” he said. Jennifer Spang, a partner in tax accounting for PricewaterhouseCoopers, stresses that there’s nothing new in the accounting rules for deferred tax assets, “but the current economy is making that evaluation particularly challenging. Some companies that historically have been profitable are now seeing losses in particular quarters or years. Companies that have not had to look at it as closely in the past are having to look at it more.” Accounting rules tell companies to look at all evidence—both positive and negative—for a given deferred tax asset, and to give weight to each piece of evidence, Spang says. “Evidence that is objectively verifiable will have more weight than subjective evidence,” she says, meaning actual losses or earnings are more meaningful than projections. Various tax rules allow for losses to be carried back into prior years or carried forward into future years, which also factors into the analysis, she adds. Ramping Up Scrutiny Layne Albert, also a managing director at Alvarez & Marsal Taxand, says the firm is seeing “significant involvement” lately from audit firms on the deferred tax asset analysis, with local offices engaging national offices on sensitive calls. “We’re seeing an intolerant risk appetite by the large accounting and attest firms,” he says. The firm is advising all of its clients to take the initiative in their analysis of deferred tax assets and to get auditors involved in the discussions early, to avoid last-minute surprises during the audit. “Prepare in advance the written analysis that your attest firm is almost certainly going to require,” Lamela says. “Make the case for why you don’t need a valuation allowance, or if you need an allowance why it should be partial.”  Albert warns that companies hit with a last-minute challenge by auditors may face not only an unexpected valuation allowance, but also a question about whether there’s a potential weakness in internal control over the tax provision process. Rich Walton, a tax lawyer with the law firm Buchalter Nemer, says the analysis around deferred tax assets has also become more intense not only because of pressure from regulatory and tax authorities. Companies have had to take a closer look at their deferred tax assets and deferred tax liabilities in recent years as a result of guidance published in 2006 in Financial Interpretation No. 48, Accounting for Uncertainty in Income Taxes. (It is now contained in the Accounting Standards Codification largely under ASC Topic 740, Income Taxes.) The FIN 48 analysis caused companies to be more cautious with what they claim about deferred tax assets, Walton says. Then a recent federal appeals court case recently gave tax authorities greater access to the work papers supporting the analysis, which made companies even more careful, he adds. Even further, governments at all levels are starved for tax revenue, and have dispatched more auditors to search for unreported corporate taxes. “The macroeconomic pressure on deferred tax assets is forcing companies to reevaluate the likely usefulness of these assets on the balance sheet,” Walton says. The burden for tax departments, Walton says, is “more time, and more thoughtful, more careful documentation of conclusions.” Companies shouldn’t just abandon viable deferred tax assets because of the current pressure, he says, but “the ability to justify keeping these deferred assets on the balance sheet really hinges on research, thoughtfulness, and the ability to answer tough questions.”  Spang agrees that virtually every company should be addressing the issue. After all, she says, “If you look around business in general, what sector hasn’t been impacted by the economy?”