When a company reports a deferred tax asset the

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When a company reports a deferred tax asset, the company implies that it will, more likely than not, receive a future tax benefit equal to the deferred tax asset. If the company is uncertain about the future tax benefit, it records an allowance to reduce the asset. How can we gauge the adequacy of a valuation allowance account? We might assess the reasons for the valuation account (typically reported in the tax footnote). We might examine other companies in the industry for similar allow- ances. We might also review the MD&A for any doubt on company prospects for future profitability. We can quantify our analysis in at least three ways. First, we can examine the allowance as a ' percentage of the deferred tax assets. For Pfizer, this 2010 percentage is 5.62%; see below. We also want to gather data from other pharmaceutical companies and compare the sizes of their allowance accounts relative to their related deferred tax assets. The important point is that we must be com- fortable with the size of the valuation account and remember that management has control over the adequacy and reporting of the allowance account (with audit assurances). Deferred tax asset ........................ .............................. Valuation allowance . Valuation allowance as a percent of total deferred tax asset . $15,921 $ 894 5.62% $16,260 $ 353 2.17% Second, we can examine changes in the allowance account. During a year, circumstances change and the company might be more or less assured of receiving the tax benefit. In that case, the company might decrease or increase its allowance account. The valuation allowance in 2010 is con- siderably larger than the previous year even though the deferred tax asset arising from net operating losses has decreased. This implies that during the year, Pfizer has revised downward the amount of net operating losses that the company expects to be able to use to reduce future taxes. Third, we can quantify how a change in the valuation allowance affects net income and i effective tax rate (see Exhibit 5.7). To see this, recall that increases in the valuation allowance affect tax expense in the same direction, dollar for dollar. This in turn, affects net income (in the opposite direction) again, dollar for dollar. For Pfizer, its 2010 valuation allowance increased by $541 million ($353 million to $894 million), which increased tax expense and decreased net income by $541 mil- lion. This is not a large effect on income for Pfizer. However, changes in valuation allowances can have (and have had) marked effects on net income for numerous companies. One final note, reduc- tions in the deferred tax asset valuation account can occur as a result of unused loss carryforwarcls: in that case, a company reduces the deferred tax asset and the related valuation allowance, which is similar in concept to the write-off of an account receivable discussed in Module 6. For our analysi we must remember, however, that in the absence of expiring loss carryforwards, a company can increase current-period income by deliberately decreasing the valuation allowance. Knowing thar such decreases can boost net income, companies
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