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Parker Conrad

Deferred tax assets (or liabilities) show investors the value of steps a company has taken which strengthen or weaken its future tax position. A deferred tax asset represents some tax advantage the company will benefit from in the future, while a deferred tax liability represents some additional tax penalty the company believes it is exposed to down the line.

Deferred tax assets can arise for a number of reasons:

• Operating Losses: Deferred Tax Assets are the silver lining for a company that is otherwise losing money. Because losses today count against any profits the company might earn in the future, these losses, while bad, create an asset in the form of a lower tax bill down the road. For example, if a company lost $10 million today, in the future, its next $10 million in profits would be tax-free -- it would only pay taxes once it recouped its losses. As a result, a company that ceases operations after large losses is not entirely worthless - another company could swoop in and buy the distressed company for its deferred tax assets, and use these assets to offset its own future profits for tax purposes. However, these losses can only be carried forward for tax purposes for seven years - so if the company doesn't earn $10 million within seven years of its initial $10 million loss, it would lose any remaining tax benefit from this loss.

• Differences in the timing of revenue recognition between tax and accounting calculations: Sometimes the rules set by tax authorities for when a company accrues revenues and expenses for tax purposes deviate from generally accepted accounting principles. For example, a company that sells extended warranties will estimate, in advance, how much it will have to pay to fix broken items in the future. For income reported to investors, it subtracts out these expected payments in advance, reducing its income. However, the IRS won't allow it to claim these losses against its income until it actually has to pay them out, years down the line. So, the income the company reports to the IRS is larger than what it reports to shareholders, increasing its tax bill in the short term. Because this difference in reported income is a timing issue -- when should the payments to fix broken merchandise be recognized? -- in the long term both the calculations reported to the IRS and those reported to shareholders should match up. If the company's estimates on how much it will have to pay to fix broken merchandise are correct, it will eventually pay out that amount, and its tax bill in the future will be lower as a result of those expenses. Therefore, the company reports this expected future tax benefit as a deferred tax asset in order to show investors the tax benefit, tomorrow, that arises from pre-payment of taxes today.

Valuation Allowance

Sometimes, a company expects it will not be able to realize the the benefits of its deferred tax assets. For example, If a company loses $10 million, it would record a deferred tax asset representing the decrease in taxes on its next $10 million in earnings. However, if the company doesn't expect profits for the next several years, and doesn't expect to earn $10 million in the seven-year time horizon before these deferred tax assets expire, it can't record them at full value - because the company won't be able to take advantage of this tax benefit.

If a company expects there is more than 50% chance it will not be able to realize some of its deferred tax assets (because it future income won't be large enough to take full advantage of these tax breaks), it must report a valuation allowance to account for this.

A valuation allowance depends a great deal on management assumptions - who's to say how high a company's future profits will be, and therefore whether the company will be able to take advantage of its deferred tax assets? If management changes its assumptions about future earnings, the valuation allowance changes, and the difference is reported as earnings, today. So, management at companies with valuation allowances can directly change reported earnings today by changing assumptions about earnings tomorrow. Changing a valuation allowance is one way that management can manage or manipulate its earnings.