Deferred Tax

You have completed a preliminary draft of the year-end financial statements and notes and have distributed it to members of the board of directors for review. According to your computations, the company will be reporting yet another loss—the third one in a row. The company has taken full advantage of the carryback provisions of the tax law. With this year’s loss, the company will carry forward some of the loss. As a result, you have correctly recorded a deferred tax asset. However, because of continued losses, you have used a valuation allowance account to reduce the amount of the deferred tax asset.

Some board members sent emails questioning the use of a valuation allowance account. You responded that if losses continue, the entire deferred asset amount may not be realized and that it is your professional opinion that sufficient evidence exists to justify the use of a valuation allowance account. Management believed that the company will have a turnaround. However, you have heard this talk about a turnaround in prior years, yet management seemed unsuccessful in implementing desired changes. In past years, you have always had prior years’ profits against which you could offset losses. Now the board is questioning your loyalty to the company as well as your judgment. Write a two to three page memo to present to the board at the next meeting discussing the following:

1. Justification for using a valuation allowance account.

2. Other factors you considered in valuing the deferred tax asset account.

3. As the accountant, state your concerns about management’s ability to turn around the company.

4. The effects the valuation allowance account’s journal entry will have on this year’s income statement. Did net income go up or down? With this journal entry, are you contributing to the company’s loss?