Beware of the "naked credits" that could show up as deferred tax liabilities on corporate balance sheets.

That’s the warning from PwC, at least, in a recent alert to companies that may need to take a valuation allowance, or a downward adjustment, for deferred tax assets.

Deferred tax assets and deferred tax liabilities arise in corporate balance sheets as a result of timing differences between financial reporting and tax reporting; DTAs represent expected future tax benefits while DLAs represent tax amounts that will have to be paid in the future, all based on events that occurred during the financial statement period. Accounting rules, specifically Accounting Standards Codification 740, Income Taxes, require companies to write down or adjust deferred tax assets if the latest evidence suggests those benefits won’t be realized after all.

PwC says the naked credit effect becomes a concern when DTLs related to indefinite-lived assets—think real estate, goodwill, and certain other intangible assets that have no defined limit to their lifespan—can’t be used as a source of taxable income to recognize the DTAs that are on the balance sheet. The PwC alert describes three different scenarios where companies might face a valuation allowance that would lead to a naked credit on the balance sheet.

“The naked credit results when you’re not allowed to net everything,” said Gregg Dluginsky, managing director with tax firm True Partners Consulting. Companies could be prevented from netting their DTAs and DTLs under any number of scenarios arising from the intermingling of complex tax and accounting rules.

A valuation allowance is a tough pill for any company to swallow because it flows through to earnings and the balance sheet, said Dluginsky. “Now if you have a naked credit, it’s even worse,” he said. “This is a trap for the unwary.”

The naked credit scenario could be commonplace for companies that historically have been profitable but over the past few years have lost money instead, said Dluginsky. Companies may have had DTAs on the books but lately have had to adjust them downward because more recent losses leave no good basis for assuming those tax benefits will really come to pass.

“If an auditor is evaluating your deferred tax assets and you’ve made money, there’s significant evidence you will make money, so there’s no need for a valuation allowance,” said Dluginsky. With the downturn, however, if a company has lost money in recent periods, auditors may not be so easily convinced of a company’s rosy prognosis, forcing a downward adjustment.