It has been three years since community banks started feeling the effects of the economic downturn, and as losses have piled up, so have deferred tax assets.

The assets, which are created when a bank loses money, can be used to offset future income taxes. But as losses continue to mount, auditors are increasingly worried that some banks will not make enough money to use the tax benefit, and they are requiring more companies to reduce the value of those assets.

"I definitely think that the longer the industry continues to struggle on the profitability front, you're going to see more and more of those writedowns … being taken," said Matthew Kelley, an analyst with Sterne, Agee & Leach.

Such a writedown, known as a valuation allowance, is an expense that can swell quarterly losses and reduce capital ratios. It also can raise doubts about a company's ability to post profits.

"It's a significant red flag," said Stephen Moss, an analyst at Janney Montgomery Scott. "You do have to ask if that company is going to be a going concern."

Although the trend started last year, several companies that recently trimmed deferred tax assets include First Federal Bancshares of Arkansas, Hampton Roads Bankshares Inc. in Norfolk, Va., Pinnacle Financial Partners in Nashville and Santa Lucia Bancorp in Atascadero, Calif.

Deferred tax assets are considered a tax benefit, and have the effect of narrowing pretax losses in the year that the deferred tax asset is created. The assets are held on the balance sheet as capital, and when a bank returns to profitability, it can use the deferred asset to offset its income tax.

Yet when a company records losses over several quarters, auditors start to question whether the benefit will ever be used. Auditors must determine whether a company is "more likely than not" to utilize the deferred tax assets.

After three years of cumulative pretax losses, accountants often require a company to take a "valuation allowance," and temporarily reduce the assets, or write them off entirely. The valuation allowance is recorded as an expense, and has the effect of widening losses.

Dan Trigg, a partner with McGladrey & Pullen LLP, said such allowances are becoming more prevalent. "It's gradually picked up steam as the banking industry continues to deteriorate," he said.

This trend became clear recently in second-quarter earnings announcements as companies said they reduced the value of their deferred tax assets.

For instance, the $5 billion-asset Pinnacle said last month that it took a $17.4 million valuation allowance, which increased its quarterly losses by 53 cents a share. And on Aug. 10 Hampton Roads said it would revise its annual 2009 and first-quarter 2010 results after taking a $56 million valuation allowance for 2009 and a $14.3 million allowance for the first quarter.

First Federal of Arkansas revised its 2009 and first-quarter results after reducing the value of its deferred tax assets by $14.7 million last year, to $11.9 million. The allowance, coupled with a higher provision for loan losses, increased its year-end loss to $46.2 million, from the $27 million that it initially reported.

The Financial Accounting Standards Board developed the standards for evaluating deferred tax assets, but they are not hard-and-fast rules. Analysts say auditors are becoming more conservative in their interpretation of the guidelines, especially at larger firms such as PricewaterhouseCoopers and KPMG.

Trigg said there's not much wiggle room when a company has had three years of losses. "Until they actually deliver and show they can execute a plan that generates taxable income, recognition of the DTA is very difficult," he said.

Meanwhile, analysts say the company announcements are causing others to worry that their auditors will require valuation allowances, too.

Western Alliance in Las Vegas, Wilmington Trust Co. in Delaware and First Commonwealth Financial in Indiana, Pa., all have significant concentrations of deferred tax assets, and have raised the possibility in their 10-Q reports of a future valuation allowance.

"Companies that are still posting quarter after quarter of losses are just going to have a more difficult time proving to their auditors that they deserve to carry this big tax asset," Kelley said.

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