Assessment of deferred tax assets
I find myself sitting in a meeting with a CFO asking me, “Is a deferred tax asset a ‘real’ asset”? I notice the auditors start shifting in their seats, the bankers trying to look calm and collected and a general feeling of mild panic spread through the room. This particular CFO is technically up to date with his accounting standards and has been making the auditors work rather hard for their money, but deferred tax discussions seem to make even the best of us nervous. I find myself enjoying this debate, so I rise to the occasion and decide to take the bait and try to convince my client that their deferred tax asset is indeed a “real” asset. I decide to go with the Framework argument, and keep the “because IFRS says so” card for another day.
The Framework argument revolves around the core of the asset definition, namely, is there a future economic benefit? The deferred tax asset that we are discussing has arisen due to an unutilised tax loss carry-forward. Under South African tax legislation the tax loss will be carried forward to reduce tax payments in future periods, therefore this is a future economic benefit and conceptually is an asset. My client has correctly processed the following current tax computation and deferred tax journal entry to recognise the tax loss carry-forward deferred tax asset:
The next thing to consider in terms of the Framework is the recognition criteria. Firstly, is the future economic benefit (future tax saving) probable? Secondly, can the amount thereof be reliably measured? The fact that we have just calculated the deferred tax asset from the tax loss carry-forward means that the second requirement is satisfied. The probability of future economic benefit is another story all together. Before applying the detail of IAS 12, let’s finish the consideration in terms of the Framework. In order for the future economic benefit (i.e. future tax saving) to be probable, it would need to be more likely than not that there is at least R950 000 in future taxable income in order to utilise this tax saving. The probability criteria are more stringent in IAS 12 when dealing with deferred tax assets from unused tax loss carry-forwards. The standard requires there to be “convincing evidence” of sufficient taxable profit to utilise the tax loss carry-forward, which increases the requirement from mere probability to virtual certainty.
The result of all of this is that there has to be an assessment of the recoverability of the deferred tax asset at reporting date. The starting point for such an assessment is to review the deferred tax balance calculation and check if there is convincing evidence of future taxable income in the form of a taxable temporary difference balance. Taxable temporary differences will result in increased future taxable income to utilise the tax loss carry-forward deduction in future periods.
The applicable deferred tax balance calculation is as follows:
The total “future benefit” of the tax loss carry-forward is a future tax saving of R266 000. Based on the figures at reporting date there is convincing evidence of R728 571 future taxable income (i.e. the taxable temporary difference balance). This is insufficient to utilise the full future tax deduction of R950 000. Assuming that there is no other convincing evidence of future taxable income (for example cash budgets and future client revenue contracts), a portion of the deferred tax asset will need to be unrecognised to the amount of R62 000.
It is important to account for this assessed loss carry-forward in these two components. Firstly, the unrecognised portion (the R62 000) will be a part of the tax expense reconciliation and will be required for correct and complete disclosure. Secondly, the unrecognition of a deferred tax asset has a signalling affect to investors and lenders. The fact that management has unrecognised a portion of the deferred tax asset informs users of financial statements that there is no convincing evidence of future taxable profits. From an investor perspective this is vital for pricing models and decisions, and may alter market participant pricing that generally assumes that losses are not expected to persist. (Hayn, C., 1995).