National Bank Appeals Process:
Appeal of Treatment of Net Deferred Tax Assets (Third Quarter 1995)
Background
A bank appealed an opinion issued by the chief accountant on
August 17, 1994, regarding the appropriate accounting treatment for its net
deferred tax assets. The opinion concluded that the bank should report a
valuation allowance for the full amount of its deferred tax assets. The
assets in question totaled $502,000 as of December 31, 1993, and $529,000 as of
December 31, 1994; they represent approximately 20 percent of Tier 1 capital.
The bank's appeal notes that its external CPA firm assisted
bank management in implementing FAS 109 during 1992. The local firm rendered
unqualified opinions on the bank's 1992 and 1993 financial statements. The
bank's internal auditor, also a CPA, concurs with management's accounting
treatment of the deferred tax assets. Both of these CPAs are governed by the
guidelines adopted by the American institute of Certified Public Accountants
(AICPA), including the Code of Professional Ethics. Bank management does not
believe the OCC has shown that these professionals fail to meet the standards
of competency and independence. Therefore, the appeal questions how the OCC can
take a position opposing a CPA firm engaged in practice according to the
standards designed and implemented by the accounting profession.
The bank showed a net loss before taxes of $91,000 in its
first year of operation. It reported operating profits the next six years
ranging form $68,000 to $585,000. The bank recorded operating losses in 1992
through 1994 in the amounts of $1.4 million, $700,000, and $150,000. Management
projects a $120,000 operating loss for 1995. The bank's appeal contends that
these losses are anomalies, caused primarily by unusually large loan
write-offs. It attributes the losses to weak credit underwriting standards and
poor supervision by prior senior management. Although improvement is noted, the
November 7, 1994 report of examination concluded that the overall condition of
the bank remains unsatisfactory and the bank continues to have high levels of
classified and nonperforming assets.
Discussion
FAS 109, Accounting for
income Taxes, is the GAAP
accounting rule for determining the appropriate accounting for deferred tax
assets. Under the standard, an asset is automatically recorded for a loss carry
forward. However, FAS 109 recognizes that these assets might not be realized.
Therefore, it requires a bank to assess the likelihood of their realization.
The bank must reduce its deferred tax assets by a valuation allowance if, based
on the weight of available evidence, it is more likely than not that some
portion or all of the deferred tax asset will not be realized. The valuation
allowance should be sufficient to reduce the deferred tax asset to an amount
that is more likely than not to be realized.
The weight given to the potential
effect of negative and positive evidence should be commensurate with the extent
to which it can be objectively verified. The more negative evidence that exists
(a) the more positive evidence is necessary, and, (b) the more difficult it is
to support a conclusion that a valuation allowance is not needed for some
portion or the entire deferred tax asset. It
is difficult to conclude that a valuation allowance is not needed when there is
negative evidence such as cumulative losses in recent years.
Realization of the deferred tax asset is dependent upon
taxable income expected to be generated within the carry forward period
available under the current tax law. Currently, the Internal Revenue Service
permits a 15 year carry forward period. However, the chief accountant believes,
and the ombudsman concurs, that it is difficult to objectively assess the
likelihood of realizing projected profits beyond a relatively short period of
time. The Chief accountant believes that this is the predominant view of the
largest CPA firms. This concern is especially relevant for a bank that does not
have a strong earnings history, or otherwise indicates a lack of stability.
Accordingly, the ombudsman concurs that forecasts of profits beyond three to
five years are estimates that have a high degree of uncertainty. Therefore, it
is consistent with generally accepted accounting principles to consider the
subjective nature of such estimates and assign them less weight than historic
operating results. Further, absent substantial positive evidence, it is
extremely difficult to objectively verify projections for future earnings
during successive years of operating losses.
The primary negative evidence is the actual operating losses
(1992, 1993, 1994, and projected 1995) and the remaining risk in the loan
portfolio. The bank believes that the underlying reason for the risk in the
loan portfolio (i.e., prior management) has been addressed and its projections
take into account the remaining risk in the portfolio. The bank identified the
change in management as the most significant positive evidence that credit
problems and corresponding losses will not continue. The board of directors
instituted comprehensive loan policies and procedures and engaged the services
of a bank consulting firm to perform semiannual independent loan reviews. The
formal agreement currently in place required the development of a capital plan,
which was ruled reasonable by OCC. The bank considers its 15 year earnings
projections to be ultraconservative. Bank management also believes that the
bank's external auditors are in a better position than the OCC to make the
required professional accounting determinations regarding generally accepted
accounting principles for the fair presentation of financial statements.
Conclusion
After considering all the facts and circumstances of the
bank's situation, the ombudsman concurred with the chief accountant that the
bank should establish a valuation allowance for the full amount of its net
deferred tax assets. In the ombudsman's view the evidence showed it was not
"more likely than not" that the bank would realize any of its deferred tax
assets. The recent operating losses, the lack of strong earnings history, and
the remaining risk in the loan portfolio provide significant uncertainty
surrounding the bank's projections of future earnings. However, this appeal
decision does not prohibit the bank from recognizing some or all these deferred
tax assets at some point in the future. Management may reduce the valuation
reserve when new evidence arises supporting greater probability of the asset
being realized. For example, once the bank starts earning positive operating
income, it may be justified in reducing the amount of the valuation reserve.
Further, FAS 109 allows an institution to consider tax
planning strategies as a possible source of income in determining the amount of
valuation allowance required. The bank's appeal identified four tax planning
strategies that management could use to realize the bank's deferred tax assets.
Of these strategies, sale of the bank building seems to provide the most likely
opportunity to generate taxable revenue. The ombudsman is not advocating sale
of the bank building, as such, a decision by the board of directors must be
predicated on a strategy that is in the best interested of the bank. Also, the
ombudsman did not have sufficient information to assess whether a sale of the
building meets the requirements of FAS 109 for tax-planning strategies. A
qualifying tax-planning strategy is an action that: (a) is prudent and
feasible, (b) an enterprise might not take, but would take to prevent an
operating loss of tax credit carry forward from expiring unused, and (c) would
result in realization of deferred tax assets. If management can show that sale
of the bank building meets these requirements, the bank may be able to justify
a smaller valuation allowance. The other tax planning strategies mentioned in
the bank's appeal may change the timing in which the bank recognizes certain
expenses, but do not generate revenue. Because of uncertainty about the bank's
ability to generate profits, the ombudsman concurs with the chief accountant
that changing the timing of expenses would not likely have a significant
impact.
A secondary issue raised in the bank's appeal concerned
inaccurate narrative comments about the bank's capital levels in the most
recent report of examination. The supervisory office has since sent the bank a
letter acknowledging the miscalculations. The field office director attached a
corrected report of examination page to the letter to the bank.
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