The four federal bank and thrift regulatory agencies are considering whether to permit current recognition for regulatory purposes of deferred tax assets. The Financial Accounting Standards Board had issued Statement of Financial Accounting Standards 109 in February, which permits such recognition under generally accepted accounting principles. Following are excerpts from the comment letter by the American Bankers Association to the Federal Financial Institutions Examination Council, through which the regulators set accounting policy. (For story on FAS 109, see The Mortgage Marketplace, Oct. 12, page 2.)
While the [Federal Financial Institutions Examination Council] has proposed several alternatives to the treatment of deferred tax assets. the agency staff has indicated its preference for the existing OCC and FDIC rule of limiting the recognition of deferred tax assets to the amount of taxes previously paid that can be recovered through carrybacks. The basis of this staff position appears to be the uncertainty that a banking institution might generate sufficient future taxable income to realize the net deferred tax assets. The uncertainty about this asset seems no greater than the uncertainty that banks will be repaid on outstanding loans. Indeed, FAS 109 requires banks to establish an offsetting valuation allowance, which reduces the asset to the extent of the uncertainty about realization, analogous to the reserve for loan losses, which reflects the uncertainty about some of the assets in the loan portfolio.
It is further suggested in the request for comment that institutions unable to realize their net deferred tax assets may be more likely to pose a risk to the deposit insurance funds. This agency staff position constitutes a lowest common denominator approach to bank supervision. Continuing to apply this outdated regulatory limitation on deferred tax assets is directly contrary to the differential supervision techniques recently adopted by the bank agencies such as risk-based capita J, brokered deposits and risk-based premiums. In those cases, the agency actions designed to be "more sensitive to the differences to risk profiles among banking organizations." The agencies can and should adopt an approach to deferred tax assets, which, like risk-based capital and risk-based premiums, respond to the different financial conditions among banks.
The ABA believes the most effective approach to bank supervision with respect to deferred tax assets is to adopt FAS 109. The regulatory agencies will benefit from having information from the bank management, subject to review by the outside auditor, as to their expectations about the bank's future taxable income. This will facilitate the ability of banking agencies to distinguish, in both the call reports and in measuring capital, between the many healthy banking institutions that will be able to realize their future tax deductions and the few institutions that will not realize them. The FASB rejected an across-the-board liquidation approach for recognizing deferred tax assets and the bank regulatory agencies should do so as well.
As indicated in the FFIEC request for comment, net deferred tax assets may arise in ordinary banking business activities from temporary differences between financial statement treatment and tax law treatment of expenses. most notably the allowance for loan losses and write-downs on foreclosed properties. Every bank, even the most healthy, has a deferred tax asset associated with its allowance for credit losses. In addition, many state laws have no tax carryback for corporations. Since state taxes can be a significant item of expense for commercial banks, this can result in a significant deferred tax asset. These examples demonstrate that deferred tax assets may arise solely as a result of the tax laws and not because of any weakness in the underlying condition of the institution or negative prospects about its ability to earn taxable income in the future, and realize the asset.
FAS 109, like the even more restrictive FAS 96, correctly recognizes that deferred tax assets can be realized by means of simple tax planning strategies, such as selling off appreciated assets and/or switching from tax-exempt assets to taxable assets that yield taxable income. The availability of these tax planning strategies should make it abundantly clear why commercial banks have consistently realized deferred tax assets (both recorded and unrecorded) and why they are likely to continue to be able to do so. Banking Circular 202 and BL-36-85 do not consider or distinguish those situations and effectively deny recognition of deferred tax assets because of the structure of the federal or state tax law. The current agency rules do not consider the health of the institution or the likelihood, no matter how certain, that the deferred tax asset will be realized in the near future.
In contrast to the current agency rules, FAS 109 requires bank management to evaluate the positive and negative factors affecting the prospects of realization of a deferred tax asset, permitting recognition of the asset based on that evaluation. There are two distinctive features of the FAS 109 process that are significant in a bank supervision context. First, on the basis of the positive and negative evidence, the bank is required to establish a valuation allowance that would offset, in whole or in part. the deferred tax asset. For example, if the bank management and the bank's outside accounting firm (especially now under the new audit provision in the Federal Deposit Insurance Corporation Improvement Act) concluded that it was more likely than not that the bank would realize only 40% of the deferred tax asset, then a valuation allowance equal to the remaining 60% would be established on the bank's books.
While there has been speculation that banks would use the adoption of FAS 109 to artificially exaggerate their financial health, it is unrealistic to believe that would be the case. One cannot assume that an institution would knowingly misstate its financial condition, since safeguards (such as prudent bank management, external audits, regulatory examinations, and SEC scrutiny) exist. Based on reactions expressed to the ABA from its members, we believe that prudent analyses to the ABA from its members, we believe that prudent analyses will not only be required by external sources, but will be closely evaluated internally. Consistently, the bankers have indicated that they will take a conservative approach for recognizing the deferred tax assets based on future taxable income, so as not to overstate its impact on their books. As one banker describes the situation, he plans to start from zero and confirm the ability of the bank to realize each dollar of the asset. This conservative approach would be more prudent than recognizing a much larger percentage of the deferred tax asset today, but having to reduce that amount in the future through a charge to current earnings if it had been overly optimistic.
The significance of this conservative approach is underscored by a second feature of FAS 109 as adopted by FASB. The components of the net deferred tax asset that are recognized must be disclosed in the financial statements. This means that any time an institution increases or decreases its valuation allowance, that Information will be fully disclosed to all users of the financial statements. Indeed. It is likely that the outside auditors will require disclosure of the basis for not having a valuation allowance. The recognition of a net deferred tax asset on the basis of forecasted income will actually have the effect of being an early indicator of the bank management's Judgment about the health of the institution. Thus, banks are not likely to be overly aggressive in recognizing net deferred assets with minimal valuation allowances.