Adjusted deferred assets: Meaning, Criticisms & Real-World Uses

What Is Adjusted Deferred Assets?

Adjusted deferred assets represent the net amount of deferred tax assets that a company expects to realize in the future, after accounting for a valuation allowance. This concept is crucial in financial accounting and taxation, specifically under accrual accounting principles, as it reflects the future tax benefits a company anticipates receiving. Deferred tax assets arise when a company has overpaid taxes or paid taxes in advance, or when it has losses or tax credits that can be carried forward to offset future taxable income. The "adjusted" part signifies that these potential future benefits have been evaluated for their likelihood of realization.

History and Origin

The concept of deferred tax assets and their adjustment through a valuation allowance is deeply rooted in the evolution of accounting standards designed to accurately portray a company's financial position and performance. In the United States, the Financial Accounting Standards Board (FASB) provides comprehensive guidance on accounting for income taxes through ASC Topic 740, "Income Taxes." This standard mandates the recognition of deferred tax assets and liabilities for the future tax consequences of events that have been recognized in an entity's financial statements or tax returns¹⁴.

A critical aspect of ASC 740, and thus of adjusted deferred assets, is the requirement to assess the recoverability of deferred tax assets. If it is "more likely than not" that some portion or all of a deferred tax asset will not be realized, a valuation allowance must be established to reduce the asset to its estimated realizable amount¹¹, ¹², ¹³. This principle gained significant attention and clarification over time, particularly with changes in tax laws and economic conditions that could drastically impact a company's ability to utilize future tax benefits. For instance, the Securities and Exchange Commission (SEC) issued Staff Accounting Bulletin (SAB) 118 to provide guidance on the application of ASC Topic 740, especially in the context of significant tax law changes, clarifying how entities should account for and adjust their deferred tax assets and liabilities¹⁰.

Key Takeaways

Adjusted deferred assets represent the net amount of deferred tax assets a company expects to realize, taking into account the likelihood of future taxable income.
The adjustment is made via a valuation allowance, which reduces the gross deferred tax asset amount if future realization is deemed "more likely than not" to fail.
This adjustment impacts a company's balance sheet and can influence its reported tax expense on the income statement.
The determination of a valuation allowance requires significant professional judgment, considering both positive and negative evidence regarding a company's ability to generate sufficient future taxable income⁹.
Adjusted deferred assets provide a more conservative and realistic view of a company's future tax benefits, aligning with the principles of financial reporting and U.S. GAAP.

Formula and Calculation

The calculation of adjusted deferred assets involves a straightforward subtraction:

\text{Adjusted Deferred Assets} = \text{Gross Deferred Tax Assets} - \text{Valuation Allowance}

Gross Deferred Tax Assets: These arise from temporary differences between the financial accounting (book) basis and the tax basis of assets and liabilities, as well as from net operating loss (NOL) and tax credits carryforwards.
Valuation Allowance: This is a contra-asset account established when it is "more likely than not" that some portion or all of the gross deferred tax assets will not be realized. The assessment considers various factors, including a company's history of losses, future taxable income projections, and available tax planning strategies⁷, ⁸.

For example, if a company has gross deferred tax assets of $1,000,000 but determines, based on its assessment of future profitability, that $300,000 of those assets will likely not be realized, it would record a valuation allowance of $300,000. The adjusted deferred assets would then be $700,000.

Interpreting the Adjusted Deferred Assets

Interpreting adjusted deferred assets involves understanding a company's future financial health and its ability to utilize tax benefits. A higher amount of adjusted deferred assets suggests that a company has significant future tax savings that are deemed realizable, which can be a positive indicator for investors and analysts. Conversely, a large or increasing valuation allowance against deferred tax assets signals concerns about a company's future profitability.

When a company records a valuation allowance, it essentially indicates that it does not expect to generate enough taxable income in the future to fully utilize its deferred tax assets. This can reduce reported net income in the period the allowance is recorded, as the reduction in the deferred tax asset is recognized as a tax expense or reduces a tax benefit. Analysts often scrutinize the valuation allowance to gauge management's expectations for future earnings and the quality of those earnings.

Hypothetical Example

Consider "Innovate Tech Inc.," a new software company. In its first few years, Innovate Tech incurs significant research and development expenses and reports losses for financial reporting purposes, even though some expenses are deductible for tax purposes later. This creates temporary differences and a net operating loss (NOL) carryforward, leading to gross deferred tax assets.

Let's say at the end of Year 3, Innovate Tech has:

Gross Deferred Tax Assets: $5,000,000 (primarily from NOL carryforwards and deductible temporary differences).

However, due to its early stage and unpredictable market, the company's management assesses the likelihood of generating sufficient future taxable income to utilize these assets. Given a history of cumulative losses and a competitive market, they determine it is "more likely than not" that $2,000,000 of these deferred tax assets will not be realized.

To reflect this, Innovate Tech establishes a valuation allowance:

Record Gross Deferred Tax Assets: Initially, the company would recognize the $5,000,000 as a deferred tax asset on its balance sheet.
Establish Valuation Allowance: A valuation allowance of $2,000,000 is recorded. This is a contra-asset account.
Calculate Adjusted Deferred Assets:
Adjusted Deferred Assets = $5,000,000 (Gross DTA) - $2,000,000 (Valuation Allowance) = $3,000,000.

On Innovate Tech's balance sheet, the adjusted deferred assets would be presented as $3,000,000. This adjustment impacts the income statement by increasing the tax expense (or reducing the tax benefit) in the period the allowance is established.

Practical Applications

Adjusted deferred assets are critical in several areas of finance and accounting:

Financial Analysis: Analysts use adjusted deferred assets to get a more accurate picture of a company's true financial health and future profitability. A significant or growing valuation allowance can be a red flag, indicating management's concerns about generating future taxable income.
Investment Decisions: Investors often consider the quality of a company's earnings and assets. Adjusted deferred assets provide insight into the reliability of future tax benefits. If a company consistently maintains a high valuation allowance, it may signal underlying business challenges impacting its ability to generate profits.
Mergers and Acquisitions (M&A): During M&A transactions, the acquiring company meticulously evaluates the deferred tax assets of the target company. The potential realization of these assets, after any necessary adjustments for a valuation allowance, can significantly impact the valuation of the acquisition⁶.
Regulatory Compliance: Companies must adhere to strict accounting standards, such as U.S. GAAP's ASC 740, when accounting for income taxes and deferred assets. Regulators like the SEC monitor these disclosures closely. The Internal Revenue Service (IRS) also provides guidelines, such as IRS Publication 536, which details how taxpayers, including businesses, can figure and apply net operating loss (NOLs), a common source of deferred tax assets⁵.

Limitations and Criticisms

While providing a more realistic view, the determination of adjusted deferred assets, particularly the valuation allowance, involves significant subjectivity. This subjectivity is a primary limitation and source of criticism:

Management Judgment: The assessment of whether it is "more likely than not" that deferred tax assets will be realized relies heavily on management's forecasts of future taxable income. These forecasts can be optimistic or pessimistic, potentially leading to audit adjustments or questions about the quality of financial statements ⁴.
Impact on Earnings: The establishment or reversal of a valuation allowance can have a discrete and material impact on a company's reported net income in a given period, which may not always reflect the underlying operational performance.
Lack of Informational Value for Investors: Some academic research suggests that, for certain markets or types of companies, deferred tax assets, even before adjustment, may have limited informational value for investors, as their realization is often contingent on future uncertain events², ³. This challenges the perceived utility of reporting these assets in detail.
Complexity: The accounting for deferred tax assets, especially when considering the nuances of temporary differences and various sources of taxable income, can be complex, making it difficult for non-experts to fully grasp the implications of the adjustments made.

Adjusted Deferred Assets vs. Deferred Tax Liabilities

Adjusted Deferred Assets and Deferred Tax Liabilities both arise from temporary differences between financial accounting rules and tax laws, but they represent opposite sides of the spectrum.

Adjusted Deferred Assets: These represent future tax benefits. They occur when a company has paid more tax than it owes in the current period, or when it has losses or credits that can reduce future tax payments. The "adjusted" part specifically refers to the reduction for a valuation allowance if it's unlikely the full benefit will be realized. They are recorded on the asset side of the balance sheet and reflect probable future economic benefits in the form of reduced tax payments.
Deferred Tax Liabilities: These represent future tax obligations. They occur when a company has recorded less tax expense for financial reporting purposes than it will eventually owe to the tax authorities in future periods. This often happens when revenue is recognized earlier for financial accounting or expenses are deducted later for tax purposes (e.g., accelerated depreciation for tax). They are recorded on the liability side of the balance sheet and represent probable future sacrifices of economic benefits in the form of increased tax payments.

The primary confusion arises because both deal with timing differences in taxation. However, adjusted deferred assets signify future tax savings, while deferred tax liabilities indicate future tax payments.

FAQs

Why are deferred tax assets "adjusted"?

Deferred tax assets are adjusted by a valuation allowance to reflect the amount that is "more likely than not" to be realized. This adjustment ensures that the financial statements present a realistic estimate of the future tax benefits a company expects to receive, based on its ability to generate sufficient taxable income.

What factors lead to a valuation allowance?

A valuation allowance is primarily established when there is significant negative evidence that outweighs positive evidence regarding the realization of deferred tax assets. Common negative factors include a history of cumulative losses in recent years, projected future losses, or the expiration of net operating loss (NOL) or tax credit carryforwards unused¹.

How do adjusted deferred assets impact financial statements?

Adjusted deferred assets are reported on the asset side of the balance sheet. The initial recognition or changes to the valuation allowance directly affect the tax expense or benefit on the income statement in the period they occur. This means that an increase in the valuation allowance will typically increase current tax expense, reducing net income.

Is the adjustment of deferred tax assets subjective?

Yes, the adjustment of deferred tax assets is highly subjective. It requires management to make significant judgments and estimations about future profitability, economic conditions, and the effectiveness of tax planning strategies. This subjectivity can lead to variations in how companies assess and report their adjusted deferred assets.