1 Unit
CPD technical article
DTA measurement can be a concern because of the potential delays in recovering net operating losses, explains Graham Holt
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IAS 12, Income Taxes, says that a deferred tax asset (DTA) is recognised for deductible temporary differences, unused tax losses and unused tax credits to the extent that it is probable that taxable profit will be available against which the deductible temporary differences can be utilised.
The exception is where the deferred tax asset arises from the initial recognition of an asset or liability (other than in a business combination), which does not affect accounting profit or taxable profit. Unlike many International Financial Reporting Standards (IFRS), IAS 12 determines the value of a deferred tax asset, not on the basis of fair value or discounted values but at its nominal amount.
The measurement of a DTA can be a concern simply because of the potentially long period of time before the net operating losses are recovered. The accuracy of the estimate of future taxable profits must be questioned in such a case and, as the amounts cannot be discounted under the standard to reduce any future impact, entities need to be aware of the inherent limitations in their forecasts.
The availability of sufficient taxable temporary differences and any tax-planning opportunities that allow the recovery of DTAs are normally dependent on a jurisdiction’s tax laws and regulations. However, there may still be uncertainty in relation to available temporary differences and tax planning opportunities, as both items will need confirmation by the relevant tax authorities.
The assessment of a DTA is heavily dependent on judgment. The level of judgment may be dependent on the nature of the tax loss that occurs. If the loss was due to a non-recurring event then there will be little judgment required, but if the entity has sustained tax losses for many years, then greater subjectivity may be involved in predicting future profits.
Where prior years’ losses are significant, evidence of future taxable profits may be difficult to verify. IAS 12 states that where an entity has a history of recent losses, there should be convincing evidence of sufficient future taxable profits before a DTA can be recognised. A time limit on the carry forward of tax losses may be significant in the assessment of a DTA.
Probability is the key judgment in this analysis. The nature of the ‘probability’ assessment is not defined in IAS 12. However, IAS 37, Provisions, Contingent Liabilities and Contingent Assets, defines the term ‘probable’ by stating that this means ‘more likely than not’ and thus if a deferred tax asset is ‘more likely than not’ to be recovered, then recognition is appropriate. The main judgment is the level of evidence of future taxable profits, consisting of a breakdown of projected taxable profits for each taxable entity, and the probability thereof.
Impairment testing
The availability of future taxable profits may be determined by reference to the entity’s own business-planning forecasts. The process of future forecasting should be familiar to most entities due to impairment testing carried out on tangible and intangible assets.
Impairment tests generally are based on approved budgets, often adjusted for risk and internal bias. Thus the expectation would be that the assessment of DTAs could be based on the same information and be broadly consistent with the assumptions used for impairment testing. However, the forecasting of future taxable profits does differ from impairment testing in several ways, and some significant adjustments may need to be made to align this analysis to the requirements for DTA valuation.
IAS 36, Impairment of Assets, defines the recoverable amount of a cash-generating unit (CGU) as the higher of the value in use and the fair value less the cost to sell. In order to determine the DTAs of an entity, value-in-use assumptions would be the relevant basis for evaluating the forecasts of their future taxable income. However, the forecasts for DTA purposes might include certain events that would be excluded from impairment calculations under IAS 36.These might include the impact of future restructuring activities or enhancements in asset performance.
The cashflow forecasts should be converted to taxable profits using local tax laws. For example, tax-deductible expenses that may not be included in a
value-in-use calculation will be taken into account in calculating taxable profit, and non-taxable items should be excluded. Thus, the conclusion may be that the CGU is not impaired but that the future taxable profits are not sufficient to justify recognising a DTA.
IAS 12 indicates that the recoverability of DTAs should be assessed with reference to the same taxation authority and the same ‘taxable entity’. The ‘taxable entity’ may consist of multiple cash-generating units, or a cash-generating unit may consist of more than one taxable entity. As can be seen, the ‘taxable entity’ may not be the same as the cash-generating unit that is the basis for impairment testing. This may mean that the forecasts used for impairment testing may have to be disaggregated in order to assess the valuation of carry-forward losses. This could result in no DTA being recognised, even though the cash-generating unit is profitable.
In many jurisdictions, there are time limits on the recovery of tax assets and this will represent a cut-off for the cashflow projection period in determining the DTA. In some sectors, special purpose entities (SPEs) are used to hold licences or patents, and the life of the SPE can be limited to that of the patent or licence. This length of life will, in turn, be the cut-off for the cashflow projection period in determining the DTA.
Conflicts
Projections for DTA purposes must be fairly consistent with the assumptions made in other areas of the financial statements. An exception arises where IAS 12 conflicts with other IFRSs. When impairment testing under IAS 36, if the risks are high in terms of the estimation of future cashflows, the discount rate will be adjusted to take into account the risk that the future cashflows will differ from the estimates. IAS 12, however, does not permit the discounting of DTAs (or liabilities), and therefore entities need to consider how they can appropriately reflect risk in their forecasts of future taxable profits.
A possible challenge by regulators, auditors and tax authorities may influence the behaviour of entities. The information in financial statements must be neutral and objective. The best form of evidence will be a strong earnings history or existing long-term contracts that will generate stable future profits.
The carrying amount of deferred tax assets should be reviewed at the end of each reporting period and reduced to the extent that it is no longer probable that sufficient taxable profit will be available to allow the benefit of part or all of that deferred tax asset to be utilised.
Recently the IFRS Interpretations Committee identified diversity in practice regarding the recognition of a deferred tax asset that is related to a debt instrument measured at fair value. As a result, the International Accounting Standards Board (IASB) issued an exposure draft (ED), Recognition of Deferred Tax Assets for Unrealised Losses, in August 2014.
An unrealised loss on a debt instrument does not intuitively seem to fit the definition of a deductible temporary difference if the entity does not expect to deduct this loss for tax purposes. However, the IASB confirms its view that unrealised losses on debt instruments measured at fair value and measured at cost for tax purposes give rise to a deductible temporary difference regardless of whether the debt instrument’s holder expects to recover the carrying amount of the debt instrument by sale or by use.
Further, the IASB proposes to clarify the extent to which an estimate of future taxable profit includes amounts from recovering assets for more than their carrying amounts. The recovery of an asset for more than its carrying amount is unlikely to be probable where, say, the asset was recently impaired, but is probable where it is measured at cost and used in a profitable operation.
An entity recognises deferred tax assets only if it is probable that it will have sufficient future taxable profits. Future taxable profits would intuitively seem to mean that this figure would be the one on the bottom line of the tax return. However, it is proposed that future taxable profits would be the amount before the reversal of deductible temporary differences.
The proposals also clarify that the deductible temporary differences should be assessed for recognition on a combined basis, taking into account the different types of income (deductions) under the jurisdiction’s tax law. Tax law may restrict the sources of taxable profit against which a deductible temporary difference can be utilised. If there were no such restrictions, then the entity would assess a deductible temporary difference in combination with others. However, if tax law restricts the utilisation of losses, then a deductible temporary difference would be assessed only in combination with other deductible temporary differences of the appropriate type. The impact of the ED on the financial statements will depend on the tax environment and how the entity currently accounts for deferred tax.
Graham Holt is director of professional studies at the accounting, finance and economics department at Manchester Metropolitan University Business School
1 Unit
CPD technical article
"Entities need to consider how they can appropriately reflect risk in their forecasts of future taxable profits"