Judgment! Judgment! Judgment! Judgment! Judgment! Judgment! Judgment! Judgment! OK?
The telecommunications industry is very dynamic, driven by technological developments and changes in the competitive and regulatory environment. Due to the significant capital expenditure involved in building infrastructure, investment recovery periods tend to be longer than in many other industries. In the past, a number of telecom operators have recorded significant start-up trading losses and losses due to impairment charges on licences or goodwill and other assets resulting from business combinations. Depending on local tax legislation, operators can use these losses to offset future taxable income.
Companies are required to assess the accumulated losses and the recoverability of any related deferred tax assets (DTA) each year. The amounts involved are often material. The table below shows the DTAs recognised in the 2018 financial statements of a selection of major telecom operators.
The unrecognised (potential) deferred tax assets for some of these operators are even larger. For example, KPN reported total available (unrecognised) tax losses carried forward amounting to EUR 672 billion; Telefonica 11 billion; Vodafone EUR 6 billion; Telecom Italia (TIM Group) EUR 2 billion and Telenor NOK 3 billion.
Significant judgment is involved in determining deferred tax assets
Many telecommunications companies share the same practical issues in determining the value of deferred tax assets. Twelve of the fourteen telecom operators listed in Figure 1 reported the valuation of DTAs as a critical accounting estimate in their 2008 financial statements. The disclosures they made indicate that operators struggle particularly in assessing whether sufficient taxable income will be available against which the carry forward losses can be utilised. This paper discusses how companies respond to this issue in practice.KPN Annual Report 2018 Note 8 Taxation
The relevant international accounting standard is IAS 12 Income Taxes. The standard provides that a DTA should be recognised for all deductible temporary differences, to the extent that it is probable that taxable profit will be available against which the deductible temporary difference can be utilised. Similarly, a DTA should be recognised for the carryforward of unused tax losses and unused tax credits, to the extent that it is probable that future taxable profit will be available against which the unused tax losses and unused tax credits can be utilised.
Unlike many of the more recent International Financial Reporting Standards, the asset is determined not on the basis of its fair value or discounted values, but rather at its nominal amount. This is a particular concern due to the generally long periods required to recover the net operating losses. The farther a company needs to look into the future to estimate taxable profits, the harder it will be to make a reliable estimate. As discounting cannot be applied to reduce the relative impact on the value of later years, companies need to find ways to deal with the inherent uncertainties in their forecasts.
An analysis of the recoverability of deferred tax assets considers:
- The availability of sufficient taxable temporary differences Valuing deferred tax assets
- The probability that the entity will have sufficient taxable profits in the future, in the same period as the reversal of the deductible temporary difference or in the periods into which a tax loss can be carried back or forward Valuing deferred tax assets
- The availability of tax planning opportunities that allow the recovery of DTAs Valuing deferred tax assets
The first and last of those factors generally are a matter of applying relevant fiscal laws and regulations. For available temporary differences, there may be judgment resulting from uncertain tax positions to the extent that tax assessments are not final. Tax planning opportunities have an inherent uncertainty insofar as they have not yet been confirmed by the tax authorities.
The thoroughness of the analysis should reflect the materiality and level of judgment
By its nature, a deferred tax asset is evidenced solely by the underlying analysis. As can be seen in Figure 1, for many telecommunications companies, the potential DTA is material, or even fundamental, to the financial statements as a whole. In addition, determining probabilities in the assessment of a DTA is highly judgmental. The level of judgment will depend also on an entity’s track record with regard to the predictability of its core earnings. When tax losses are caused by a non-recurring event for an otherwise profitable company, the nature of the judgment is different than that for an entity that has had more loss-making years in recent history. The thoroughness of the analysis should reflect both the materiality of the (potential) DTA and the level of judgment involved. Valuing deferred tax assets
The key judgment in the analysis relates to probability. The term probable is not defined in IAS 12; but with reference to IAS 37 Provisions, Contingent Liabilities and Contingent Assets, it is generally defined as ‘more likely than not’. In other words, if it is more likely than not that all or any portion of the deferred tax asset will be recovered, that part of the asset should be recognised. Valuing deferred tax assets
Example disclosure of ‘likelihood’ criterion
A factor that may drive behaviour is the probability of challenge by regulators and the company’s stakeholders, or even the tax authorities. We commonly hear that management believes the risk of challenge is higher for recognising an unduly high DTA than for an unduly low DTA. Valuing deferred tax assets
That does not mean companies should be excessively conservative in assessing the valuation of DTAs. According to the IFRS framework, the information contained in financial statements must be neutral, that is, free from bias. The exercise of prudence in preparing the financial statements does not justify deliberately understating assets, because the financial statements would not be neutral and, therefore, would not have the quality of reliability. Valuing deferred tax assets
Both favourable and unfavourable evidence should be considered in the analysis. Objectively verifiable evidence generally will be given greater weight than less objectively verifiable evidence. A strong earnings history or existing long-term contracts that generate stable future profits will provide the most objective evidence in assuming future profitability when assessing the extent to which a DTA can be recognised. Valuing deferred tax assets
Greater care is needed, however, if prior years’ losses are very significant relative to expected annual profits. In that case, positive evidence of future taxable profits may be less objectively verifiable. Therefore, evidence of future taxable profits may be assigned lesser weight in assessing the appropriateness of recording a DTA when other evidence is unfavourable. Specifically, in the case of a history of losses that did not result from identifiable causes that are unlikely to recur, it is unlikely that a DTA can be recognised. IAS 12 explains that when an entity has a history of recent losses, convincing evidence of sufficient future taxable profits is required before a DTA can be recognised. The entity should have regard to any time limit on the carryforward of tax losses.
However, whilst it may be that the longer into the future an assessment is required the less probable any particular level of taxable profit becomes, there should be no arbitrary cut-off in the time horizon over which such an assessment is made.
Also read: Valuing deferred tax assets