Professional judgment frameworkAccounting for income taxes—valuation allowanceBackground
Asbat Pharmaceuticals (Asbat) is a leading pharmaceutical company that has been in existence for 22 years. Asbat has a calendar year-end and is audited annually. Asbat only operates in the United States and is not subject to state or local income taxation. Its total assets, exclusive of the deferred tax asset, are $3.5 million.
In the early years, Asbat operated at a net loss. After its fifth year of business, upon the release of its first drug, Asbat began reporting annual net profits. These profits continued until two years ago, when, in 2018, Asbat once again began reporting a net loss, which has been primarily attributable to significant research and development costs.
The following table presents the loss figures for Asbat. Asbat’s relevant statutory tax rate is 21% and the company did not have any permanent book-tax differences during 2018, 2019 or 2020. Asbat did not establish a valuation allowance to offset the deferred tax asset in 2018 or 2019.
A table sowing the loss figures for Asbat. Asbat’s relevant statutory tax rate is 21% and the company did not have any permanent book-tax differences during 2018, 2019 or 2020201820192020Pretax book loss$ (900,000)$(1,890,000)$(775,000)Net temporary differences (210,000) (60,000)(110,000)Taxable loss(1,110,000)(1,950,000)(885,000)Statutory tax rate 21% 21% 21%Impact on the deferred tax asset balance233,100409,500185,850Net loss (after tax) *$(666,900)$(1,480,500)$(589,150)Deferred tax asset balance$233,100$642,600 $828,450Valuation allowance*–––Net deferred tax asset balance*$233,100$642,600$828,450
*Prior to determining the need for a valuation allowance in 2020.
Asbat has 100,000 common shares outstanding with no dilutive securities. Thus, its pretax loss per share for 2020 is $7.75. The current consensus analyst forecast for net loss per share (after tax) is $7.
Asbat is assessing the need to record a valuation allowance to offset the deferred tax asset balance created by the net operating loss carryforward. While the company has reported losses in the past three years, management anticipates positive income in the future. The executives of Asbat do not anticipate any fundamental shift in its business in the future. However, the company is currently in the final research and development stage of a new drug that has tremendous market opportunity. Management believes that this drug will be on the market within three years based on the company’s past R&D experience with its most recent prior drug release.
The income projections for the next five years prepared by the CFO are presented below. The CFO determined that, while a carryforward has an indefinite time period to consider, looking out at a period beyond five years was too unpredictable. However, the CFO does anticipate continued future taxable income in 2026 and beyond based on the potential long-term impact of the new drug and lack of any known competition.
The CFO has been with Asbat for his entire career and has been extremely competent in terms of preparing income projections and meeting forecasts. The pretax income projections that exclude the impact of the new drug are based on reliable historical data on income and trends. The income effect of the new drug is based on information gathered and modified from the boost to income that Asbat experienced when its most recent significant drug was released. There have been no actual or expected changes in tax laws indicating a potential change in the statutory tax rate. The projections provided are the same that have been shared with analysts and investors.
The CFO obtained a reversal schedule for the existing taxable temporary differences relating to the gross deferred tax liability at December 31, 2020, prepared and clerically tested by the junior tax accountant. This schedule was reviewed by the tax director. The schedule indicated that there would be no reversals scheduled in the foreseeable future.
A table showing The CFO obtained a reversal schedule for the existing taxable temporary differences relating to the gross deferred tax liability at December 31, 2020, prepared and clerically tested by the junior tax accountant. This schedule was reviewed by the tax director. The schedule indicated that there would be no reversals scheduled in the foreseeable future.20212022202320242025Pretax book loss, excluding new drug$(750,000)$(600,000)$ (525,000)$ (490,000)$ (350,000)Income effect of new drug2,000,0003,500,0003,750,000Pretax book (loss) income(750,000)(600,000)1,475,0003,010,0003,400,000Net temporary differences(110,000)(110,000) (110,000) (110,000) (150,000)Future taxable (loss) income (860,000)(710,000)1,365,000 2,900,0003,250,000Limitation on carryforwards80%80%80%Future taxable income available to offset carryforward 1,092,0002,320,0002,600,000Statutory tax rate21%21%21%21%21%Impact on deferred tax asset balance**180,600149,100 (229,320) (487,200) (441,630)Beginning of year deferred tax asset balance828,4501,009,0501,158,150928,830441,630End of year deferred tax asset balance$1,009,050$1,158,150$928,830$441,630$ _
**For 2025, possible offset would be $546,000, but there is only $441,630 left in the deferred tax asset account balance.
As the junior accountant, the CFO has asked you to provide him with an analysis of the need for a valuation allowance account to offset the deferred tax asset. The CFO has informed you that the tax director has said that Asbat does not have any available tax-planning strategies to realize the deferred tax asset. The CFO has suggested that beyond looking at ASC 740 for guidance on this determination, she also recommends that you read paragraphs 99 through 103 in the Basis for Conclusions in SFAS No. 109.
Required
- Reference the professional judgment framework handout and application template included here Download here.
Professional Judgment Framework Application Scenarios AFIT Valuation Allowance
- For December 31, 2020, using your judgment, perform an analysis of the need for a valuation allowance to offset part, or all, of the deferred tax asset created by the net operating loss carryforward. Using the professional judgment framework, complete the application template for all process steps and provide the appropriate information in the documentation column for your own use in answering the next requirement.
- Using the information you documented regarding the overarching considerations and the specific considerations for each process step in the framework, use the tool below to document your judgment in a draft memorandum format that you will provide to the CFO (not to exceed 300 words) which is also your initial response to the main question: Is there a need for a valuation allowance to offset part, or all, of the deferred tax asset created by the net operating loss carryforward?
- Be sure to include specific references to the applicable guidance as appropriate.
- Upon completing your documentation, make certain that you are able to address the following considerations:
- Is the documentation sufficient to support your judgment and initial response?
- Can another professional understand how you reached your conclusion (including why reasonable outcomes and possible alternatives identified were not selected)? Explain your answer.
