Valuing deferred tax assets – How 2 best account it in IAS 12

Valuing deferred tax assets

Judgement! Judgement! Judgement! Judgement! Judgement! Judgement! Judgement! Judgement! OK?

The telecommunications industry is very dynamic, driven by technological developments and changes in the competitive and regulatory environment. Due to the significant capital expenditure involved in building infrastructure, investment recovery periods tend to be longer than in many other industries. In the past, a number of telecom operators have recorded significant start-up trading losses and losses due to impairment charges on licences or goodwill and other assets resulting from business combinations. Depending on local tax legislation, operators can use these losses to offset future taxable income.

Companies are required to assess the accumulated losses and the recoverability of any related deferred tax assets (deferred tax asset) each year. The amounts involved are often material. The table below shows the deferred tax assets recognised in the 2018 financial statements of a selection of major telecom operators.

Valuing deferred tax assets
Deferred tax assets 2018 Telecom Industry

The unrecognised (potential) deferred tax assets for some of these operators are even larger. For example, KPN reported total available (unrecognised) tax losses carried forward amounting to EUR 672 billion; Telefonica 11 billion; Vodafone EUR 6 billion; Telecom Italia (TIM Group) EUR 2 billion and Telenor NOK 3 billion.

Significant judgment is involved in determining deferred tax assets

Many telecommunications companies share the same practical issues in determining the value of deferred tax assets. Twelve of the fourteen telecom operators listed in Figure 1 reported the valuation of deferred tax assets as a critical accounting estimate in their 2008 financial statements. The disclosures they made indicate that operators struggle particularly in assessing whether sufficient taxable income will be available against which the carry forward losses can be utilised. This paper discusses how companies respond to this issue in practice.

Valuing deferred tax assets
KPN Annual report 2018

Valuing deferred tax assets
Orange Annual Report 2018

The relevant international accounting standard is IAS 12 Income Taxes. The standard provides that a deferred tax asset should be recognised for all deductible temporary differences, to the extent that it is probable that taxable profit will be available against which the deductible temporary difference can be utilised. Similarly, a deferred tax asset should be recognised for the carryforward of unused tax losses and unused tax credits, to the extent that it is probable that future taxable profit will be available against which the unused tax losses and unused tax credits can be utilised.

Unlike many of the more recent International Financial Reporting Standards, the asset is determined not on the basis of its fair value or discounted values, but rather at its nominal amount. This is a particular concern due to the generally long periods required to recover the net operating losses. The farther a company needs to look into the future to estimate taxable profits, the harder it will be to make a reliable estimate. As discounting cannot be applied to reduce the relative impact on the value of later years, companies need to find ways to deal with the inherent uncertainties in their forecasts.

Telecom operator X has significant carryforward losses as a result of licence and network impairments recognised in the past amounting to EUR 20 billion. These carryforward losses do not expire. In recent years, the operator has been profitable and expects to sustain its profitability. Accordingly, the operator recognises a deferred tax asset. The current profit level is EUR 100 million (taxable profit). Based on that profit level, utilising the carryforward losses in full will take 200 years.

An analysis of the recoverability of deferred tax assets considers:

The first and last of those factors generally are a matter of applying relevant fiscal laws and regulations. For available temporary differences, there may be judgment resulting from uncertain tax positions to the extent that tax assessments are not final. Tax planning opportunities have an inherent uncertainty insofar as they have not yet been confirmed by the tax authorities.

The thoroughness of the analysis should reflect the materiality and level of judgment

By its nature, a deferred tax asset is evidenced solely by the underlying analysis. As can be seen in Figure 1, for many telecommunications companies, the potential deferred tax asset is material, or even fundamental, to the financial statements as a whole. In addition, determining probabilities in the assessment of a deferred tax asset is highly judgmental. The level of judgment will depend also on an entity’s track record with regard to the predictability of its core earnings. When tax losses are caused by a non-recurring event for an otherwise profitable company, the nature of the judgment is different than that for an entity that has had more loss-making years in recent history. The thoroughness of the analysis should reflect both the materiality of the (potential) deferred tax asset and the level of judgment involved. Valuing deferred tax assets

The key judgment in the analysis relates to probability. The term probable is not defined in IAS 12; but with reference to IAS 37 Provisions, Contingent Liabilities and Contingent Assets, it is generally defined as ‘more likely than not’. In other words, if it is more likely than not that all or any portion of the deferred tax asset will be recovered, that part of the asset should be recognised. Valuing deferred tax assets

Example disclosure of ‘likelihood’ criterion

Valuing deferred tax assets
Nippon Telecom Annual Report 2018

A factor that may drive behaviour is the probability of challenge by regulators and the company’s stakeholders, or even the tax authorities. We commonly hear that management believes the risk of challenge is higher for recognising an unduly high deferred tax asset than for an unduly low deferred tax asset. Valuing deferred tax assets

That does not mean companies should be excessively conservative in assessing the valuation of deferred tax assets. According to the IFRS framework, the information contained in financial statements must be neutral, that is, free from bias. The exercise of prudence in preparing the financial statements does not justify deliberately understating assets, because the financial statements would not be neutral and, therefore, would not have the quality of reliability. Valuing deferred tax assets

Both favourable and unfavourable evidence should be considered in the analysis. Objectively verifiable evidence generally will be given greater weight than less objectively verifiable evidence. A strong earnings history or existing long-term contracts that generate stable future profits will provide the most objective evidence in assuming future profitability when assessing the extent to which a deferred tax asset can be recognised. Valuing deferred tax assets

Greater care is needed, however, if prior years’ losses are very significant relative to expected annual profits. In that case, positive evidence of future taxable profits may be less objectively verifiable. Therefore, evidence of future taxable profits may be assigned lesser weight in assessing the appropriateness of recording a deferred tax asset when other evidence is unfavourable. Specifically, in the case of a history of losses that did not result from identifiable causes that are unlikely to recur, it is unlikely that a deferred tax asset can be recognised. IAS 12 explains that when an entity has a history of recent losses, convincing evidence of sufficient future taxable profits is required before a deferred tax asset can be recognised. The entity should have regard to any time limit on the carryforward of tax losses.

However, whilst it may be that the longer into the future an assessment is required the less probable any particular level of taxable profit becomes, there should be no arbitrary cut-off in the time horizon over which such an assessment is made.

Also read: Valuing deferred tax assets

Future tax losses

Valuing deferred tax assets

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Something else -   Deductible temporary tax differences

Something else -   Uncertainty in income tax measurement

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