Valuation Allowance for Deferred Tax Assets

This memo is to assess the establishment of valuation allowance for Deferred Tax Assets. I also explain the current sources of deferred tax for Packer, Inc. Applying GAAP, I will advise not using a valuation allowance of 60% of deferred tax assets.

I. Sources of deferred taxes

Deferred tax liabilities

A deferred tax liability is recognized for temporary differences that will result in taxable amounts in future years. In Packer, Inc’s case, depreciation has been recognized as deferred tax liabilities. Packer uses straight-line depreciation, for tax purposes, the cost of the depreciable recourses may have been deducted faster than that for financial reporting purposes.

Deferred tax assets

A deferred tax asset represents the increase in taxes refundable in future years as a result of deductible temporary differences existing at the end of the current year. Some deferred tax assets include, pension and other post employment benefits, policy and warranties, capitalize R&D, foreign credit and carry-forward and others. For example, company can recognize tax benefits for the warranty tax deduction that arise from future liability settlement because the warranty deduction is not allowed until paid. Besides, tax deduction for such deductible temporary differences as pension and other postretirement benefits will only occur in distant future date (50 years in Packer, Inc’s case).

II. Assessment of the valuation allowance

A valuation allowance is used when it is more likely than not that the company will not realize all or portion of the deferred tax asset (FASB 740-10-30-5). Positive and negative evidence should be considered carefully, to determine if establishment of valuation of allowance is required. Packer, Inc has been using a 40% valuation allowance for deferred tax asset.

Financial consequence

Packer, Inc will triple the total tax expense and half the net income if it plans to switch valuation allowance from 40% to 60%. Moreover, there will be a 2% drop in the Return on Assets value and a 20% drop and Return on Equity value accordingly.