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Appeal of Treatment of Net Deferred Tax Assets (Third Quarter 1995)


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.


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.


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.