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. GENERAL GUIDELINES 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. REALIZABILITY OF DEFERRED TAX ASSETS 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. …