In the new Sarbanes-Oxley environment, tax departments’ calculations of valuation allowances for deferred tax assets have come under intense scrutiny by external auditors. When financial department forecasts are used to substantiate valuation allowance determinations, tax departments are finding a lack of guidance in GAAP on format, contents, and basis of measure in forecast reporting. In addition, while external auditors view forecasts as management reports not subject to audit, tax departments are finding themselves increasingly in the position of explaining significant changesin forecasts used by management for various purposes unrelated to GAAP reporting.
The Financial Accounting Standards Board (FASB) issued Statement of Financial Accounting Standards (FAS) No. 109, Accounting for Income Taxes, in February 1992. The purpose of the statement was to establish financial accounting and reporting standards for the effects of income taxes that result from an entity’s activities in the current and preceding years. Throughout this statement, the FASB makes several references to forming a conclusion on the need for a valuation allowance when an entity has recorded cumulative losses in recent years (FAS 109: 23, 99-103). FAS 109 requires a valuation allowance if, based on the weight of available evidence, it is more likely than not that all or some portion of a deferred tax asset will not be realized.
In general, the FASB determined that when an entity reported cumulative pretax losses for financial reporting in the current and two preceding years, this should be considered significant negative evidence that a future benefit of deferred tax assets may not exist, and a valuation allowance would be required.
The FASB stopped short of imposing a mandatory valuation allowance under such circumstances due to the uncertainty of continued losses into the future. For example, the prior three years could have a cumulative net loss reported, but with a large year 1 net loss and with years 2 and 3 showing net income. Assuming years 2 and 3 are the most current tax years, the evidence would seem to indicate that the entity has returned to profitability and will most likely use tax-deferred assets in future years. As a result, the FASB concluded that the weight of positive and negative evidence would need to be examined to determine if a valuation allowance is required. Although the FASB provides a list of negative and positive factors to consider, they advised that an entity must use judgment in determining if a valuation allowance is required (FAS 109: 24, 25).
The Role of Forecasts
In practice, a key factor in making this determination is the entity’s forecast of future pretax income or loss. Depending on the type of industry and the stage of entity development (i.e., startup, developing, or mature), forecasts range from zero to ten years, with the norm in the three- to five-year range. The forecasts are primarily management reports used for internal purposes as well as market guidance for publicly traded entities. Format and content tend to vary from entity to entity because there are no specific GAAP guidelines or standard formats, such as a balance sheet, income statement, or cash flow statement (FASB Statement of Financial Accounting Concepts (FAC) No. 6, Elements of Financial Statements).
External auditors typically do not review or audit forecasts, as these reports are considered management representations, with no requirement under GAAP for external auditors to express an opinion about the contents or presentation (FAC No. 5, Recognition and Measurement in Financial Statements of Business Enterprises; GAAS Standards of Reporting). In spite of this, external auditors and internal tax teams rely on management’s forecasts to determine the need for valuation allowances under FAS 109, which are ultimately reported on balance sheets and in publicly filed reports (e.g., SEC Forms 10-Q and 10-K for publicly traded entities).
This has created a gray area for both external auditors and internal tax teams related to the determination of valuation allowances whenever an entity is not in a long-term loss position. In general, external auditors rely on management’s forecasts to confirm the internal tax team’s determinations but have difficulty either confirming or denying the basis of management’s prospective view of the entity, because an in-depth review of the methodology and support documentation is typically not performed.
When management either has not prepared forecasts or has a limited history of doing so, external auditors and internal tax teams may be required to rely on other more nebulous factors to determine valuation allowances, such as revenue trends, industry trends, and economic conditions. Because such factors are difficult to interpret relative to the entity’s prospective financial condition, determining the future benefit of tax assets and the need for a valuation allowance is problematic.
Until GAAP regulations are implemented to address this issue, management, external auditors, and internal tax teams need to work together to assure that forecasts are consistently prepared for both external and internal stakeholders, including for FAS 109 valuation allowance analysis purposes.If you would like additional information about these items, contact Mr. Koppel at (781) 407-0300 or firstname.lastname@example.org.