You have just completed a preliminary draft of the year-end financial statements

Question

You have just completed a preliminary draft of the year-end financial statements and notes and have distributed it to members of the board of directors for the upcoming board meeting. At the meeting, board members will have an opportunity to analyze, ask questions, and offer suggestions regarding the content of the statements and the accompanying notes. According to your computations, the company will be reporting yet another loss—the third in as many years. 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. At the board meeting, initial questions focus on the company’s profitability or lack thereof. Following this discussion, an astute member of the board questions the use of a valuation allowance account. She asks for your reasoning as to why a valuation allowance account is being used. You explain that if losses continue, the entire amount of the deferred asset may not be realized and that it is your professional opinion that sufficient evidence exists to justify the use of a valuation allowance account. Immediately, the board begins to question your assumption of future losses. “Of course we will be profitable next year,” says one board member. “We have a plan to turn this company around,” says another. You overhear another whisper to his colleague, “If the accountants don’t think we are going to make money in the future, why are they staying? They should get a job with a company that they think is going to be profitable.” You have heard this talk about a turnaround in prior years, yet management seems unsuccessful in implementing desired changes. In past years, you have always had prior years’ profits against which you could offset losses. But now the accounting department, of which you are the head, has openly questioned management’s intentions to report profits in the future. Now the board is questioning your loyalty to the company as well as your judgment.

1. What other factors might be considered when valuing the deferred tax asset account?

2. As the accountant, is it your place to question management’s ability to turn a company around?

3. What effect did the journal entry involving the valuation allowance account 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?

Explanation / Answer

1) tax planning can also affect the valuation, because taxable income will be reduced.A change in the tax rate or policies can also affect future taxable income on which we have to use the deferred tax asset.

2) As an accountant we have no right to question the management's ability. However going by the past results there is more than 50% probability there will be a loss therefore a valuation allowance is justified.

3)Deferred tax expense benefit account will be reduced to the extent of the valuation allowance, therefore the net income will go down. We are not contributing to the company's loss in a real sense as these entries are done only for future adjustment purposes.

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