When examining potential borrowers’ financial statements, some lenders are beginning to see something that’s unfamiliar to many of them: deferred tax assets. These are created as a result of timing differences that occur between book and taxable income for things such as depreciation and investment gains and losses.

With more companies experiencing losses the past couple of years due to the recession, many are setting up deferred tax assets associated with their operating loss carryforwards in their financial statements. And there are many others that aren’t recording these deferred tax assets, but should be.

Legitimate Tool When Used Properly
Deferred tax assets can be extremely valuable to the financial position of a small business. In fact, GAAP requires that they be included in reviewed and audited financial statements. But they also present opportunities for owners to manipulate financial information and misrepresent the true financial condition of their companies.

There are several implications that commercial lenders should keep in mind:

  • First, deferred tax assets will only show up on the financial statements of regular C corporations, not on the statements of companies that are Subchapter S corps or partnerships.
  • If you’re considering loaning money to a borrower that has experienced recent losses, ask them if there are any tax-loss carryforwards that aren’t disclosed in the financial statements. Considering them as part of your credit analysis may improve the business’s chances of obtaining financing.
  • At the opposite end of the spectrum are companies that present financial statements with significant deferred tax assets. This should raise a red flag, especially on internally generated and compiled statements. Deferred tax assets must be challenged as to whether they are more likely than not realizable.
  • Deferred tax assets can be a good “hiding spot” for companies to manipulate earnings and make their financial position look better than it really is. So do a little extra digging into these companies — talk to the COO or the company’s accountant or auditor to help you get a better feel for how realizable the deferred tax assets are. Otherwise, you could make a lending decision based on financial statements that misrepresent the company’s true financial condition.
  • The key factor with regard to the legitimacy of utilizing deferred tax assets is whether the tax-loss carryforward will be realizable in the future. In other words, how realistic is it that the company will have operating income going forward that can be offset by the tax-loss carryforward? Or put another way, is the company a legitimate going concern?
  • Also keep in mind that lenders usually deduct deferred tax assets when determining a borrower’s tangible net worth

Data Is King
Once again, the heart of this issue goes back to the reliability of the financial information presented by borrowers to their lenders. Data is king in today’s environment, and the more current the data you have access to, the easier it is to make sound lending decisions.

We can help you analyze deferred tax assets and tax-loss carryforwards on your borrowers’ financial statements and determine how likely it is that they are realizable. For assistance, please call us: 417-881-0145.