ACC 423 Assignment 2: Lucent technologies Inc.

What is the basic concept behind deferred tax accounting? Why do you think accounting rule makers at
FASB choose to require deferred tax accounting rather than have companies recognize tax expense as
the cash that is paid (or at least currently owed) to the government? Do you agree with this decision?

The basic concept behind deferred tax accounting is to assess the current tax obligation payable
and have an accounting procedure to keep track of the actual tax liability due to the government based
on the earnings before taxes on a cumulative basis.

FASB decided to require deferred accounting because taxable revenue differences, both
temporary and permanent, change the tax liability due to the government. Moreover, the government
would rather recognize a tax sooner than later and thus prefers not to wait for companies to collect cash
on accounts receivable but have a deferred accounting method that would provide a credit in futures
years to compensate for any overpayment.

It makes sense as it smoothes the tax benefit of losses over a larger period and reduces large
swings in Net Income. On the other hand, it also provides room for manipulation as revenue forecasting
is subjective and can be manipulated to fit any strategy.

What is the objective of requiring managers to consider the need for a valuation allowance for deferred
tax assets? How important is managerial judgment in arriving at the proper valuation allowance? How
useful is the valuation allowance to outsiders attempting to evaluate the company's performance?

The objective is to accurately and reasonably assess the likelihood that the deferred tax assets
will be realized; the size of the valuation allowance represents this concept. FASB 109 states that if the
company believes there is more than a 50% chance it will not be able to realize its DTA, then it must
record a valuation allowance to account for this. FASB also provides guidelines regarding what is
negative evidence (reasons that the DTA will not be realized) and positive evidence (reasons the DTA will
be realized) in helping management determine the amount of valuation allowance to realize, but these
are not strict rules.

As is evident, managerial judgment is extremely important in arriving at the proper valuation

allowance. Though recent financial performance plays a role, much of the entry into the financial
statements is dependent on forecasted expectations. If the management team changes these
expectations about future earnings and performance, it can affect the total amount allocated to the
valuation allowance.

The valuation allowance must always be looked at by outsiders in order to determine just where
it is being derived from. If the valuation allowance has been increased because the firm does not expect
to return to profitability in the near future, then it is indicative of the firm’s expectations of its future
performance. If, however, it has been increased because of a one-time bad contract with a customer,

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 ACC 423 Assignment 2: Lucent technologies Inc.

then it may be reasonable to assume that this does not reflect the company’s overall performance going
forward. The valuation allowance must be examined, but its importance is dependent on its derivation.

What are the primary deferred tax assets and liabilities listed on Lucent's financial statements? How
have they changed from 2000 to 2001? How well do the level's and changes represent Lucent's current
financial position? How do they reflect on its future financial position?

The primary DTAs listed on Lucent’s financial statements are bad-debt expense and customer
financing reserves, inventory reserves, restructuring reserves, postretirement and other benefits, NOLs,
and other operating reserves. The primary DTLs listed are pension, property, plant and depreciation, and
other. From 2000 to 2001, The DTLs have decreased. Pension has dropped by $500 million, PPE by $400
million, and other by $200 million. The DTAs have mainly increased. Bad-debt has gone up by
approximately $1 billion, inventory reserves by $350 million, restructuring reserves by $630 million,
NOLs by $2.3 billion, and the other items increased too.

The level of the total DTLs shows that the company is running low on the benefits gained from
paying into their pension account and that the accelerated depreciation benefits for tax purposes are
almost fully used. At the same time, the increase in total DTAs signifies that the company is hoping to
apply some of the tax benefits of its reserves in a future period. The increase in NOLs and the increasing
negative valuation allowance show that the company is in a bad place right now. Marking down the
valuation allowance signals that all the DTAs that it had built up are not likely to be realized. However,
the company is still assuming that it will make money in the future to apply the other DTAs towards.

Should Lucent increase their valuation allowance for deferred tax assets? If so, by how much? How would
this impact their third quarter financial statements? What evidence was important in making your
decision? What other evidence would you have liked to have in order to reach a final decision?

Statement of Financial Accounting Standards (“SFAS”) No 109, requires that a valuation allowance be
established when it is more likely than not that all or a portion of a deferred tax asset will not be
realized. A review of all available positive and negative evidence needs to be considered before making
a decision on Valuation Allowance. The FAS 109 explicitly states that in reviewing these factors
significant weight should be given to the negative facts such as cumulative losses and substantial less
weight should be accorded to subjective positive facts such as future income projection. For Lucent
technologies there is much more negative evidence than positive that Lucent Technologies will not be
able to realize its deferred assets in full. Cumulative losses for Lucent Technologies resulting from a
weak economy, industry consolidation and tight competition, weighs heavily in the overall assessment.
So we believe that Lucent should increase its valuation allowance. Quoting an exact amount for
valuation allowance would be impractical for us because valuation allowance depends a great deal on
management assumptions and projections about future income. Having said that, if we are to provide
consultation to the management we will ask them to be conservative about their future earnings

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 ACC 423 Assignment 2: Lucent technologies Inc.

projections because once the company gets profitable they can always record these assets back on their
books.

An increase in the valuation allowance will negatively impact the financial statements of the third
quarter. On the balance sheet it will reduce the deferred assets and on the income statements it will
reduce the reported earnings for the quarter. The following journal entry will be passed.

DR CR

Tax Expense (Income Statement) X

Valuation Allowance (Contra Asset) X

As mentioned above, the successive losses in the recent past weighed heavily in the suggestion for an
increase in the valuation allowance. In order to suggest a specific increase in the amount of valuation
allowance, we would like to ascertain the future earnings projections of the management and the
assumptions behind those projections.

How should management communicate their decision regarding the level of the valuation allowance in
the third quarter? Should their communication strategy differ if they choose to leave the valuation
allowance relatively low vs. a large increase in the allowance?

Regardless of the level of the Valuation Allowance management chooses to employ, these basic
principles should be followed. Management needs to clearly and concisely communicate the factors
considered when taking the Valuation Allowance. It is also necessary to communicate the fact that the
deferred tax assets are not lost but can be written back onto the books after a period of profitability.
Furthermore, management must communicate and emphasize the fact that the Valuation Allowance
charges are a non-cash event that does not have an impact on the fundamentals of the business, its
strategy, or future success.

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