This is going to be entertaining.
We have a few clients that have substantial deferred tax assets – mostly from net operating losses (NOL) carried forward during their start-up period. Tax losses for corporations are typically carried back two years and carry forward 20. The problem is that when the adjustment was made, the assumed tax rate was above 25%.
Why is this a problem?
Lets say that a company had a $400,000 loss in 2016. The assumed tax rate for book purposes was 25% and so is carrying forward NOL of $100,000 from that loss. the adjustment to initially record this was
Deferred tax asset $100,000
Income tax benefit $100,000
The income tax benefit is part of the income tax expense (benefit) line on the P&L statement.
2017 was a breakeven year, no income or loss for book purposes so the tax expense (benefit) recorded is $0.
But there is a problem.
Congress is enacting sweeping tax reform which indicates that the new tax rates are going to be 20% for 2018 and beyond.
GAAP requires that assets be reviewed for impairment at least annually. Well, this deferred tax of $100,000 is an asset. So is it impaired?
Since the law has not been signed as of today, it is not set in stone. So one argument is that, since you are not sure of the actual change, you shouldn’t reduce the asset value. However, is it more than remotely possible that the tax law will change? And if so, should the impairment be recorded?
Since both houses of congress have passed a corporate tax law which reduces taxes and the president has indicated that tax reform will be signed, all indications are that corporate tax law will change. And since, in this case, the law is expected to be in force for 2018, it appears that new tax rates are more than remotely possible. It is probably a near certainty.
So what do we do?
I think businesses need to look at their deferred tax accounts and ask if the carrying amounts are correct for their upcoming year ends, even if the tax law is not passed prior to 12/31/17. Just as importantly, I think if your company has a September, October, or November year end you probably need to look at those accounts and determine if the amounts accurately reflect possible changes.
In this particular case the client should probably record an entry to reduce the deferred tax asset to $80,000. The adjustment would be in the current year as the original adjustment was correct given the known fact patterns. So an adjustment of the prior periods tax benefit would not be correct.
You will also want to make sure you either update your tax footnote or add one to explain the changes and how your company implemented them.
The good news is that this adjustment should not have a major impact on bank loan covenants as most base their covenants on EBITDA – earnings before interest, taxes, depreciation, and amortization. No matter what the tax adjustment, EBITDA won’t change.
However, there may be still be a gotcha to this as it appears there is possibly going to be a limit to the deductibility of interest expense. Latest read was that it was capped at 30% of profit before interest. If this holds up, then it is possible that, in the example above, there might actually be taxes due.
Lets say that the Company made $50,000 before interest expense. The interest expense was $50,000 which led to the breakeven. If they cap interest, then for tax purposes, taxable income is $35,000 (50,000 X (1-30% cap)) which leads to income taxes due of $7,000. But for book purposes, the tax effect was zero, leading to the $7,000 being added to the deferred tax asset – at the same time you are reducing it for the reduction in rates.
And you thought accounting was boring.
Like I said, entertaining.
Have a great day.
Accounting Clarity 