Deferred tax asset valuation allowances

For many banks, it has been a long road through the “great recession.” However, as trends continue to improve and the ability to forecast earnings becomes more reliable, the next question on everyone’s mind is “When do I get to reverse the valuation reserve on my deferred tax assets?”

This article will give you tips on determining whether a valuation reserve continues to be necessary at your institution and provide some insight from an auditor’s perspective.

First and foremost when looking to assess a valuation allowance on deferred tax assets, it’s important to understand the individual components of your deferred tax asset inventory. Different deferred tax items can have vastly different expiration periods, utilization clauses, and state income tax issues. For example, the federal net operating loss carry-forward period is twenty years while state net operating losses have varying carry-forward periods that are typically shorter. Lastly, it is important to understand the effective tax rates not only for the current period but for future years as an enacted change in future years rates impacts the measurement of the deferred tax inventory.

Second, an objective evaluation of financial trends should be performed. These trends should begin to paint a picture of stability and provide substantive evidence that the utilization of the deferred tax assets is more likely than not. Trends that should be analyzed include (but are not limited to):

1. Recent profitability – How long and how much?
2. Recent and projected taxable income – While considering some form of uncertainty factor for the future, is it reasonable that all or a portion of the deferred tax asset will be utilized?
3. Quality of earnings – Are they considered “core earnings” or are they based on one-time revenues such as securities gains?
4. Nonperforming asset levels – Has there been significant or consistent declines in levels of nonperforming assets and how has that impacted earnings?
5. Regulatory trends – Has the institution been upgraded or had a formal agreement removed? 

While there are no bright lines identified in GAAP, interpretation and expectations can vary by reviewer. ASC 740-10-30-23 states, “A cumulative loss in recent years is a significant piece of negative evidence that is difficult to overcome.” Therefore, entities should act with care when profitability has not been achieved in recent quarters. Finally, remember that the amount of deferred tax asset includable in regulatory capital is further limited beyond the GAAP valuation allowance. Currently, regulatory capital rules limit DTAs to the lessor of 10 percent of tier 1 capital or to the amount expected to be realized in the next twelve months. Therefore, when projecting the impact of recognizing DTAs for regulatory capital purposes, management should review the call report instructions to ensure appropriate forecasting. Additionally, the BASEL III capital rules will change the amount of DTAs allowable to be included in Tier 1 Common Equity.