ACCT 352 Research Case – Fall 2022

ACCT 352 Research Case – Fall 2022
Background
Advanced Chemical Industries (ACI) is a leading pharmaceutical company. ACI only operates in the US.
Excluding the deferred tax asset, ACI total assets are $3.5 million. ACI was a profitable company. In 2018,
ACI began reporting a net loss (both book and tax loss), which has been primarily attributable to significant
research and development costs.
Now it is 2020. The following table presents the loss figures for ACI. ACI’s relevant statutory tax rate is 21%
and the company did not have any permanent book-tax differences during 2018, 2019 or 2020. ACI did not
establish a valuation allowance to offset the deferred tax asset in 2018 or 2019.
2018 2019 2020
Pretax 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
balance 233,100 409,500 185,850
Net loss (after tax)* $(666,900) $(1,480,500) $(589,150)
Deferred tax asset balance $233,100 $642,600 $828,450
Valuation allowance* – – ?
ACI 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 ACI do not anticipate any
fundamental shift in its business operations in the future. 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 experience. The income
projections for the next five years prepared by the CFO are presented below.
The CFO determined that, while NOL can be carried forward indefinitely, predicting numbers beyond the 5-
year period was impractical. However, the CFO does anticipate positive taxable income in 2026 and beyond,
because the new drug can bring long-term profit and there lacks of any known competing drugs. The CFO
has been with ACI for his entire career and has been extremely competent in terms of preparing income
projections and meeting forecasts. The income effect of the new drug is based on information gathered
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 have been shared with
analysts and investors.
The CFO obtained a schedule for the existing taxable temporary differences relating to the gross deferred
tax liability at December 31, 2020. This schedule was reviewed by the tax director. The schedule indicated
that there would be no reversals scheduled in the foreseeable future.
2021 2022 2023 2024 2025
Pretax book loss, excluding new drug $(750,000) $(600,000) $ (525,000) $ (490,000) $ (350,000)
Income effect of new drug 2,000,000 3,500,000 3,750,000
Pretax book (loss) income (750,000) (600,000) 1,475,000 3,010,000 3,400,000
Net temporary differences (110,000) (110,000) (110,000) (110,000) (150,000)
Future taxable (loss) income (860,000) (710,000) 1,365,000 2,900,000 3,250,000
Limitation on carryforwards 80% 80% 80%
Future taxable income available to
offset carryforward 1,092,000 2,320,000 2,600,000*
Statutory tax rate 21% 21% 21% 21% 21%
Impact on deferred tax asset balance 180,600 149,100 (229,320) (487,200) (441,630)*
Beginning of year deferred tax asset
balance 828,450 1,009,050 1,158,150 928,830 441,630
End of year deferred tax asset balance $1,009,050 $1,158,150 $ 928,830 $ 441,630 $ –
*For 2025, 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 for the deferred tax asset. The CFO has informed you that the tax director has said that
ACI 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
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. Document
your judgment in a draft memorandum format that you will provide to the CFO (not to exceed 2-3
pages, double space, 12 font size). Always include references to the applicable guidance.
Upon completing your documentation, make certain that you are able to address the following
considerations:
– Is the documentation sufficient to support your judgment? Specially, regarding the size of the
valuation allowance, why possible alternatives were not selected?
– Can another professional, possibly outside of the accounting field, understand what you are trying
to say, as well as how you reached your conclusion?