This memo is to assess the establishment of valuation allowance for Deferred Tax Assets. I also explain the current sources of deferred tax for Packer, Inc. Applying GAAP, I will advise not using a valuation allowance of 60% of deferred tax assets. I. Sources of deferred taxes
Deferred tax liabilities
A deferred tax liability is recognized for temporary differences that will result in taxable amounts in future years. In Packer, Inc’s case, depreciation has been recognized as deferred tax liabilities. Packer uses straight-line depreciation, for tax purposes, the cost of the depreciable recourses may have been deducted faster than that for financial reporting purposes.
Deferred tax assets
A deferred tax asset represents the increase in taxes refundable in future years as a result of deductible temporary differences existing at the end of the current year. Some deferred tax assets include, pension and other post employment benefits, policy and warranties, capitalize R&D, foreign credit and carry-forward and others. For example, company can recognize tax benefits for the warranty tax deduction that arise from future liability settlement because the warranty deduction is not allowed until paid. Besides, tax deduction for such deductible temporary differences as pension and other postretirement benefits will only occur in distant future date (50 years in Packer, Inc’s case).
II. Assessment of the valuation allowance
A valuation allowance is used when it is more likely than not that the company will not realize all or portion of the deferred tax asset (FASB 740-10-30-5). Positive and negative evidence should be considered carefully, to determine if establishment of valuation of allowance is required. Packer, Inc has been using a 40% valuation allowance for deferred tax asset.
Packer, Inc will triple the total tax expense and half the net income if it plans to switch valuation allowance from 40% to 60%. Moreover, there will be a 2% drop in the Return on Assets value and a 20% drop and Return on Equity value accordingly.
Parker’s management believes that they can manage strategies to ensure that the net deferred tax assets can be realized. There presents some positive evidence to avoid the recording of valuation allowance. First, Packer, Inc has a profitable operation history from 1995 to 1997, despite a significant loss in 1994. This is agreed by FASB, which states that a “strong earnings history coupled with evidence indicating that the loss (for example, an unusual, infrequent, or extraordinary item) is an aberration rather than a continuing condition” is a piece of positive evidence (FASB 740-10-30-22). These profits may be carried forward into the future to offset net-operating loss. Secondly, Packer may not generate any significant U.S Federal tax net operating loss carry forwards in the near future because it has the ability to utilize tax planning, such as capitalization of R&D. Thirdly, Packer has never lost deferred tax benefits due to expiration of a US net operating loss carry-forwards.
There is little negative evidence that might support the need for a valuation allowance. Firstly, losses occurred consecutively from 1992 to 1994. “A cumulative loss in recent years is a significant piece of negative evidence that is difficult to overcome”(FASB 740-10-30-23). Thus, establishing valuation allowances can be justified if Packer, Inc can prove that its operation earning is volatile against unusual events and might incur significant loss. 2. Foreign Credit Carry-forwards (a deferred tax asset) will expire in 2010 if not utilized, and a substantial portion of the State Net operating loss will not expire.
These instances might bring undesirable impact to Packer’s future operations. In conclusion, after weighing the evidence, I believe that an establishment of 60% valuation variance for deferred tax asset as a whole is not desirable, but company might carefully increase variation allowance for the portion of deferred tax asset (foreign credits carry-forward and non-expiring portion of State Net operating loss in this case) for which it is more likely than not a tax benefit will not be realized.
Courtney from Study Moose