EVALUATING THE VALUATION ALLOWANCE

Christine Czekai Bauman, Assistant Professor, The University of Wisconsin, Milwaukee, Wisconsin
John W. Gribble, Partner, PricewaterhouseCoopers, Jersey City, New Jersey
Terry D. Warfield, Associate Professor, The University of Wisconsin, Madison, Wisconsin

Brett Jones is a senior accountant with the accounting firm of BGW. On a recent audit engagement, Brett was assigned the task of evaluating the deferred tax accounting for Packer Inc. The company, founded in 1962, is a large heavy machinery manufacturer. Packer’s balance sheet at December 31, 1997 includes a deferred tax asset of approximately $22 million related to net future deductible temporary differences. However, realization of the deferred tax asset is dependent upon profitable operations in the U.S. and abroad, and future reversals of existing temporary differences. Although realization is not assured, Packer management in the past has been pretty sure that such benefits will be realized through the reduction of future taxable income. Management has carefully considered various factors in assessing the probability of realizing these deferred tax benefits.

Brett recalls the complexity surrounding the judgmental nature of accounting for deferred taxes under generally accepted accounting principles. Under Statement of Financial Accounting Standard No. 109 (FAS 109), Packer could be required to record a deferred tax asset for future deductible amounts and carry-forwards and record a valuation allowance, if it is likely that the tax asset will not be realized.

Brett also recalls that FAS 109 provides some examples of negative evidence to support recording a valuation allowance, and positive evidence to avoid recording a valuation allowance. If assessed in an unbiased fashion, reliance on such evidence should result in a valuation allowance that is