Valuation Allowance for Deferred Tax Assets

Categories: Taxation

Essay, Pages 3 (559 words)

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Deferred Tax Assets and Valuation Allowance

Deferred tax assets and liabilities are important components of a company's financial statements. Deferred tax liabilities arise when there are temporary differences between the tax basis of an asset or liability and its reported amount in the financial statements. On the other hand, deferred tax assets represent future tax benefits that a company can realize due to deductible temporary differences.

For Packer, Inc., depreciation has been recognized as a deferred tax liability. The company uses straight-line depreciation for financial reporting purposes, which may result in a difference in the timing of recognizing depreciation expenses for tax purposes.

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This creates a temporary difference that leads to the recognition of a deferred tax liability.

On the other hand, Packer, Inc. also has various deferred tax assets, such as pension and other post-employment benefits, policy and warranties, capitalized research and development expenses, foreign tax credits, and carryforwards. These assets represent future tax benefits that the company can realize in future years.

Assessment of Valuation Allowance

A valuation allowance is used when it is more likely than not that a company will not be able to realize all or a portion of its deferred tax assets. In the case of Packer, Inc., the company has been using a 40% valuation allowance for its deferred tax assets. However, it is important to carefully consider both positive and negative evidence to determine the need for a valuation allowance.

Positive evidence supporting the avoidance of a valuation allowance includes Packer's profitable operating history from 1995 to 1997, despite a significant loss in 1994.

This positive trend indicates that the company has the ability to generate profits and utilize its deferred tax assets effectively. Additionally, the company has not lost deferred tax benefits due to the expiration of U.S. net operating loss carryforwards, further supporting the argument against the need for a valuation allowance.

On the other hand, there is some negative evidence that might suggest the need for a valuation allowance. For instance, Packer, Inc. experienced consecutive losses from 1992 to 1994, which could indicate a volatile operating environment that may lead to future losses. Additionally, certain deferred tax assets, such as foreign tax credit carryforwards, will expire if not utilized by a certain date, which could impact the company's future tax benefits.

Financial Consequences

If Packer, Inc. were to increase its valuation allowance from 40% to 60%, it would triple its total tax expense and halve its net income. This would also result in a 2% drop in the Return on Assets and a 20% drop in the Return on Equity. These financial consequences highlight the importance of carefully considering the need for a valuation allowance and its impact on the company's financial performance.

Conclusion

After weighing the positive and negative evidence, it is recommended that Packer, Inc. does not establish a 60% valuation allowance for its deferred tax assets as a whole. However, the company may consider increasing the valuation allowance for specific portions of its deferred tax assets, such as foreign tax credit carryforwards, where it is more likely than not that a tax benefit will not be realized. By carefully evaluating the need for a valuation allowance and its impact on the company's financial statements, Packer, Inc. can make informed decisions regarding its deferred tax assets and liabilities.